The bull market, which just turned five years old, has benefited from being at first disbelieved and then, for nearly its entire duration, unloved. The bull had barely blown out the candles on his five-year birthday cake when the cavils and quibbles started. As in, "Isn't this bull market getting long in the tooth?" And, "Isn't this market getting expensive?" Yes, sort of, to the first question, and not really to the second. This bull is 60 months old, which qualifies it for an AARP card in the mail and lots of second-guessing. The 11 bull markets since 1945, according to S&P/Capital IQ, have averaged 4.5 years in duration. But we would note that the bull market in the 1990s took up the better part of that decade.
As for this market getting expensive, we would note that both forward and trailing P/Es remain reasonable - not cheap, but not frothy. Based on our recently revised estimates for S&P 500 earnings from continuing operations of $120 for 2014 and $127.50 for 2015, the S&P 500 is trading at 15.6 times our 2014 forecast and at 14.7 times our 2015 forecast. The 5-year trailing P/E for this market is 14.1 times, so our 2014 estimate at least is higher than the five-year average.
But consider peak P/Es in recent past bull markets. In 1995 and again in 1998-99, trailing P/Es were just under 30 times; and by mid-1999, forward P/Es had risen to 34 times. The market fell hard in 2007-08, even though valuations were not as excessive as in 1999, but that is not to say the 2007-08 market was cheap. Trailing P/Es peaked at 26.7-times in September 2007, right before the (at the time) all-time high in the S&P 500 of 1,563 reached in October 2007. Forward P/Es got as high as the low-30s in summer 2008, right before the market tumbled. In short, the current market is not cheap but also not pricey.
Where do we go from here? We likely keep stumbling forward, and stumbling has been the bull's best gait over the past five years. February's non-farm payrolls report was consistent with the kind of data point that this bull has been grazing on for 60 months. The jobs report represented a rebound from weak December and January readings; but it was not so robust that investors might conclude that an actual Fed rate hike might be near.
The Economy, Interest Rates and Earnings
The final revision to 4Q13 GDP lowered the economy's growth rate to 2.4% in the year's final quarter, from an earlier 3.2%. Now we've got the weather-impacted first quarter, which may grow at 2% or even less. Is the growth momentum in the economy finished?
We still see prospects for solid growth this year. After factoring in the 4Q13 revision, the economy grew at a 2.5% rate in 2013, which is the fastest rate since 2010. Though the net effect of this report was a reduction from earlier estimates, the underlying economy in the fourth quarter showed positive signs. Real personal consumption expenditures advanced at a 2.6% rate in 4Q13, up from 2.0% in the third quarter. Non-residential fixed investment, a proxy for corporate capital spending, advanced at a 7.3% rate, representing a meaningful uptick from 4.8% growth in the third quarter. Exports grew at a robust 9.4% rate, more than double the third-quarter pace. The principal reason for the downward revision from the preliminary reading was more moderate accumulation in inventories, which is ultimately healthy for long-term growth.
Looking forward, positive trends in consumer spending, corporate investment and exports support growth in the 2.7%-3.1% range over the next several quarters. 1Q14 could be an outlier, based on productive days lost to snow-shoveling. Even so, the solid February nonfarm payrolls report showed the underlying strength in the economy, and our current 1Q14 forecast is above consensus at just under 2.5%. With the snow melting away, we should get a clearer sense of the economy's strength and direction. We are looking for slightly better than 3% growth in quarters two through four, summing to average 3% growth for all of 2014.
Positives in our outlook include the potential for a strong spring season in the housing market, improving consumer confidence, and reduced political gridlock in Washington as government spending and outlays become better aligned. Risks in our GDP outlook include geo-political events, such as a worsening in the Ukraine situation; the potential for inflation; higher energy prices; and deceleration in emerging economies.
As 2014 was getting underway, the 10-year yield was at 3%, after market rates of interest spiked during the strong equity bull run to end 2013. Predictably, markets consolidated in the New Year; stocks pulled back in mid-single-digit percentages. Bonds rallied on concerns that the economic advance was slowing, while also fattening on money exiting the stock market. The 10-year bottomed at 2.6%. But as the spring thaw approaches, we are seeing yields creep higher. The 10-year yield is now just under 2.8%. At this time one year earlier, the 10-year yield was also creeping higher, before it would slide to record lows in May 2013.
Also of interest is the widening in the twos-tens spread. The spread between the two-year yield of 0.37% and the 10-year yield of 2.79% is 242 basis points. A year earlier, the spread between the two-year yield of 0.24% and the 10-year yield of 2.06% was 182 basis points. The resultant 60 basis point steepening in the yield curve says that that bond investors at least are anticipating a strengthening in the economy. When the yield gap shrinks and the yield curve flattens out, that is a sign that investors are anticipating a weakening trend ahead in the economy.
Over the next six months, we look for rates to gradually creep higher. Over the course of 2014, we think the 10-year yield could move sustainably above 3% and the 30-year bond yield approach or exceed 4%. We are not expecting the Fed to move during 2014, so the three-month bill likely remains at current low levels of just a few basis points above zero. During the year 2015, however, we see a rising likelihood that markets could experience the first hike in the fed funds rate since 2006.
Our final count on 2013 in S&P 500 earnings is $110.75, which is about $0.25 less than we estimated heading into 4Q13. That shave is small enough to be called a rounding error, although it may also reflect a fourth quarter that began with a government shutdown and ended buried in ice and snow.
We have also taken down our 2014 forecast slightly, to $120; our prior estimate for current year S&P 500 earnings had been $121.50. Nearly all of the reduction occurs in the first quarter, which we have brought down by $1.40 to $28.35. We could see some pent-up 1Q earnings spill into 2Q, so we have bumped up our 2Q14 estimate slightly. On balance, we are still modeling 8.4% earnings growth for 2014, reduced from an earlier 10% growth forecast again primarily by the weather-induced 1Q slowdown. However our more conservative estimates also factor in the potential for continuing emerging market turmoil to impact earnings growth.
Argus Chief Investment Strategist Peter Canelo has also introduced his preliminary forecast for 2015. Off the estimated 2014 base, Peter is modeling 6% growth in continuing operations earnings to $127.25. At present, our 2015 estimate is well below consensus; Standard & Poor's, for example, forecasts that 2015 earnings will be about $137. In our view, as the Fed begins to raise interest, perhaps in mid-2015, economic activity could be impacted by the rising cost of doing business.
Markets & Sectors
One month ago, all the major domestic equity indexes were in negative territory, with only the bond market in positive territory. One month later, all the indexes except the DJIA are positive, and all are beating the fixed income index, which did not move. In terms of relative performance in the past month, the best bounce-back has been in the Russell 2000; the small cap index has rebounded by 800 basis points since this time last month. The NASDAQ and S&P 500 are both up 500 basis points in just the past month; the S&P has swung from down 3% at the end of January to nearly up 2% as of the end of February. The DJIA has come back nearly that much, but still was 20 bps shy of breakeven as of our performance measurement. Also noteworthy this year is that growth stocks are outperforming value stocks; during 2013, value was the clear winner.
This time last year, the major indexes were in a stronger place, with most up in low double digits. The S&P 500's two month gain of 10% was prelude to a 30% upside year. If we extrapolate year-to-date gains in 2014 according to the 2013 pattern, the S&P 500 this year will be lucky to get to a 7% gain and would deliver total return below 10%. But then, the year has a long way to go.
The market in February shook off the January blues and roared to new highs. Leadership during this recovery phase included most but not all economically sensitive sectors. Compared with one month ago, financial services lost 30 bps of market weight. The big banks did not have a great earnings season, and their early momentum in restoring dividends has waned somewhat.
Other economy-sensitive sectors have fared better. Technology held its sector weight in a rising market, but consumer discretionary inched higher by 20 bps. Consumer discretionary sharply underperformed early this year, as weather and maybe some wallet exhaustion cut into housing and automotive activity. Healthcare, the leader for most of the bull market, remains in a leadership role. At 13.7%, healthcare has its highest market weighting in over a decade.
In this year's award season, the Grammy for broken record goes to Healthcare, which is the year-to-date sector leader as it has been for nearly the entire bull market. Healthcare is up 7.3% year-to-date. The only other sector up more than 5% year-to-date is the surprising utilities sector. Additionally, four sectors (energy, technology, financials, and materials) are doing better than the market. Discretionary and industrials are in positive territory but lag the broad market's 2% year-to-date gain. And three sectors are down year-to-date: staples, telecom services, and energy.
While Utilities is second-best year-to-date, this sector has relatively underperformed in the turbulent past month. Keep in mind that between our end-of-January snapshot and our end-of-February snapshot, S&P 500 total return improved by 490 basis points. Over that one month span, utilities lagged by gaining 320 bps of total return; meanwhile, healthcare led by garnering a sector-second-best 630 basis points of total return. Also faring well in the past month has been Materials, which reversed its end-of-January trend by 720 basis points. In addition to utilities, telecom services has also relatively lagged.
The sector leader board from one year ago was more clearly reflective of a risk-on market; far from being in second place, utilities were in eighth place. Another big turnaround from a year ago has been in technology, which was in ninth place last year but is now slightly above middle of the pack.
In advance of the calendar 2014 second quarter, we recently adjusted our recommended sector weights, using our six-point model encompassing momentum, relative and absolute valuation, sector conviction, and institutional input from Argus Chief Investment Strategist Peter Canelo. We have raised our recommended weightings on Energy and Materials to Overweight from Market Weight, based on our outlook for improving economic activity in emerging economies and fiscal & monetary trends that favor commodities pricing. We have reduced our recommended weighting in Consumer Discretionary to Market Weight from Overweight, primarily on signs of moderating consumer activity after a very strong recovery over 2012-13. We have also reduced our recommended weighting in Healthcare to Market Weight from Overweight, primarily on valuation; the current Healthcare sector P/E represents 149% of the five-year average P/E. Finally, we have reduced our recommended weighting in Financial Services to Market Weight from Overweight. While banks will benefit over the long term from expanding net interest spreads in a rising rate environment, the financial services industry is being hurt in the intermediate term by slowing in rate-sensitive areas such as housing and auto financing.
Our recommended sector weightings are as follows:
- Overweight: Energy, Materials, and Technology
- Market Weight: Industrials, Consumer Discretionary, Financial Services, and Healthcare
- Underweight: Consumer Staples, Telecom Services, and Utilities
Broadly, our survey of 11 global markets was down 5.0% at end of January; survey performance improved to down 3.5% as of end of February. Mature economy markets, such as the DJIA in the United States, have come back strongly in the past month. On average, the U.S., Euro Zone, Japan, Canada and DJ World index are up 390 bps in the past month. But the same cannot be said for emerging economy markets, and particularly the BRIC markets. The BRICs are down 70 bps in the past month, mainly because of Russia. While China and India have come back about 500 bps in the past month, Russia - paying an early price for its Ukrainian incursion - has declined 1100 bps. Brazil is also down in double digits this year, having worsened a further 280 bps in the past month.
Jim Kelleher, CFA, Argus Director of Research
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.