By Michael Lombardi
In the first five weeks of this year, investors bought $22.0 billion worth of long-term stock mutual funds. (Source: Investment Company Institute, February 12, 2014.)
But as investors poured money into the stock market, hoping to ride the 2013 wave of higher stock prices, stocks did the opposite and went down. The Dow Jones Industrial Average is down three percent so far this year.
Looking at the bigger picture, corporate earnings and key stock indices valuations are still stretched. The S&P 500's 12-month forward price-to-earnings (P/E) ratio stands at 15.1. This ratio is currently overvalued by roughly nine percent when compared to its 10-year average, and 15% compared to its five-year average. (Source: FactSet, February 14, 2014.)
This isn't the only indicator that says key stock indices have gotten too far ahead of themselves. In the chart below, I have plotted U.S. gross domestic product (GDP) against the S&P 500.
The chart clearly shows a direct relationship between GDP and the S&P 500. When U.S. GDP increases, the S&P 500 follows in the same direction, and vice versa. When we look at the 2008-2009 period (which I've circled in the chart above), we see that when GDP plunged, the S&P 500 followed in the same direction.
Going into 2014, we saw production in the U.S. economy decline; consumer spending is pulling back, unemployment is still an issue, and the global economy is slowing. U.S. GDP is far from growing at the rate it did after the Credit Crisis. Take another look at the chart above. In 2011, you'll see U.S. GDP was very strong; but after that, it stalled. In this environment, when GDP is struggling, historically, key stock indices struggle.
Frustration among companies in key stock indices is high as well; they are struggling to post earnings growth despite record stock buyback programs. One prime example of this is The Coca-Cola Company (NYSE:KO). The company reported a decline of eight percent in its fourth-quarter 2013 corporate earnings. Because of this, the company is planning to cut $1.0 billion in costs by 2016. (Source: The Coca-Cola Company web site, last accessed February 19, 2014.) We see this pattern across the board.
The only thing working for key stock indices is that our friends at the Federal Reserve still have their printing presses running. But we also know that the Federal Reserve is slowly putting the brakes on its printing activity.
Do investors really think that the central bank will be able to completely pull back on its quantitative easing program (which is scheduled to happen in 2014) and that key stock indices will continue to rise? With the yield on the 10-year U.S. Treasury up a whopping 88% since July 2012, there are too many factors and indicators working against the continued rally in key stock indices. The sucker's rally in stocks is near its end.