Remember the year the stock market had in 2013? Of course you do. How could any investor forget? The S&P 500 increased 30% in price, which was its biggest annual gain since 1997.
It was an outsized gain to be sure, only it didn't have as much fundamental backing as it had fun-duh-mental backing.
The market had fun with the understanding that the Fed wouldn't be moving the Fed funds rate off the zero bound anytime soon... it drew a mental charge from the expectation that the U.S. economy would be sustaining real GDP growth above 3.0% throughout 2014... and, duh, those two elements facilitated a no-brainer bullish bias.
So what if earnings per share were only up 5% in 2013. That was just icing on the cake, albeit a thin layer of icing.
Why bring this up now with the first half of 2014 essentially over?
Because the third estimate for first-quarter GDP, which showed output contracting 2.9% on an annualized basis, should have brought everybody down. To be sure, it made it very clear that the stock market got ahead of itself in pricing in the 2014 economic upturn.
Running the Basis
The first-quarter GDP reading was the worst since the first quarter of 2009 when the world was in a world of economic hurt, the Fed was just embarking on the path of quantitative easing, and the S&P 500 was trading at lowly levels it hadn't seen since 1996.
The stock market, though, traded right through the lousy GDP number on the basis that:
- It was dated information;
- It was skewed by the severe winter weather, the change in inventories, and a downward revision to health care spending that didn't seem to make any sense; and
- It was an aberration in the face of Q2 data that has been more uplifting.
Very well. We agree with the first point. It was dated information. Nonetheless, the remaining two points are a little wishy-washy on the basis that:
- Even if you reset the GDP reading to add back the negative drag from the weather (estimated to be 1.5 percentage points), the change in inventories (1.7 percentage points), and the contribution seen from health care spending before the stunning revision (1.0 percentage point), real GDP would still only be up 1.3%, which is below its five-year average; and
- Second-quarter data has been more uplifting, yet that is the case because the downturn in the first quarter lowered the base from which growth is measured.
Our second-quarter GDP forecast has been increased to 3.6% from 3.5%. In fact, most economists are looking for second-quarter growth to exceed 3.0% quarter-over-quarter on an annualized basis. The change in inventories is a big reason why. In our model, the change in inventories accounts for 2.1 percentage points of the estimated growth.
A lot of people decried the drag on first-quarter GDP from the change in inventories, implying it was simply a mathematical pressure point. If the change in inventories does in fact help boost second-quarter GDP above 3.0%, we're hard pressed to believe those same voices will be as loud in trying to talk down the strength of the GDP report.
The dirty little secret in the first-quarter GDP report that few people seem to be mentioning is that it showed the Treasury market has had things right when it comes to pricing in real economic activity.
We'll concede that some portfolio rebalancing by pension funds helped grease the slide in the 10-yr note yield early in the year. However, we'd argue that weak economic activity in the first quarter (with or without the weather effect) and the awareness that full-year GDP growth is going to fall well short of 3.0%+ have continued to feed buying efforts in the Treasury market.
At its June 17-18 FOMC meeting, the Fed lowered its central tendency projection for 2014 real GDP growth to 2.1-2.3% from 2.8-3.0%. That was before the third estimate for first-quarter GDP was released, meaning there is apt to be another downward revision with the quarterly update in September.
Notwithstanding a few post-FOMC pronouncements from Fed officials suggesting the Fed is closer to meeting its goals than people appreciate, the yield on the 10-yr note has dropped 13 basis points from where it was trading the day before the FOMC announcement. What that implies is that the Treasury market still isn't convinced the economy is on the cusp of sustaining the old normal 3.0%+ growth rate.
The stock market, on the other hand, has kept on truckin.' The S&P 500 is up 6.0% year-to-date as of this writing. That move is roughly in-line with earnings growth, so there hasn't been any real multiple expansion. Nonetheless, things are getting stretched, even with long-term rates coming down, knowing that:
- The S&P 500 was up 30% in 2013 on EPS growth of just 5%;
- The economy has clearly not lived up to the expectations embedded in the strong price gains last year; and
- The consensus EPS growth estimate for FY14 continues to come down (it is 7.6% today versus 11% at the end of 2013, according to FactSet).
What It All Means
Earnings growth is obviously an important element in driving stock market gains, yet with the S&P 500 having risen 38% in the last 18 months when blended earnings have risen just 10%, the influence of the Fed's monetary policy is unmistakable.
The stock market looked past the first-quarter GDP report because it continues to believe the six-month outlook is going to provide much better economic news and earnings growth. Like we have said in past reports, that line of thinking has persisted for more than five years now.
Six months down the road, though, has continued to produce more of the same from an economic standpoint for more than five years now.
The stock market, however, is still buying what the Fed is selling. That helps explain the large disparity between earnings growth and the price gains for the S&P 500, and why the worst GDP reading since the first quarter of 2009 was viewed with an insouciant eye.
We said in our latest market view update that it is advisable to proceed with caution in the near term since the risk-reward dynamic isn't that appealing.
That viewpoint hasn't changed, especially knowing the stock market is leaning more and more on fun-duh-mentals than fundamentals.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.