The S&P 500 closed above the magical 2,000 level on Tuesday for the first time ever. The market is also tracking to its best August performance in 14 years. So where do we go from here? Will S&P 2,000 turned out to be a major resistance point or just another speed bump on the way to higher levels?
To be truthful, there does not seem to be a lot of clarity around market direction from here despite the current consensus from market pundits that U.S. equities will continue to grind higher from current levels. Let's take a look at the Bull and the Bear case for the market for the rest of 2014 and go from there.
Yes, the multiple on the market is substantially higher that it was before the end of QE1 and QE2 which triggered declines in the market. However, the economy is also stronger. The country has had the strongest six months of job growth in over a decade. Consumer Confidence continues to rise and even gas prices have fallen a bit over the past few months. Geopolitical concerns like Ukraine, Syria and Iraq will garner headlines from time to time but should have little impact to the global economy.
In addition, earnings came in stronger than expected in the second quarter and the economy should have significantly higher GDP growth in the second half of the year. Even the housing sector is improving a bit with homebuilder confidence at its highest levels since January.
Besides, where else is an investor going to go? Interest rates have declined throughout 2014 and the ten year treasury yield stands at just 2.4%. German government debt yields are even lower and Europe remains a mess. The spread between high yield bonds and risk free debt is historically low and not offering investors much in the way of extra return for adding risk. In short, this is a TINA (There Is No Alternative) market which should continue to push equities higher from current levels.
There are myriad reasons to believe the market is vulnerable to at least a decent pull back in the months ahead. After QE1 ended, the market declined over 15% before the Federal Reserve rode to the rescue again. The end of QE2 triggered a better than 10% pull back before the Fed stepped up with QE3. With the market multiple significantly higher than it was then, and the economy still on track for just 2% GDP growth for all of 2014; discounting the possibility the market will not react negatively as the Federal Reserve ends its last quantitative easing program seems imprudent. We will not even get into the over $4 trillion balance sheet the Fed has amassed that eventually will have to be dealt with.
Yes, earnings came in above consensus during this quarter but revenue growth remains anemic at 3% to 4% year-over-year as demand is hard to come by. In addition, a good portion of those earnings gains are coming from stock buybacks and debt refinancing; hardly what I would call organic growth. M&A and IPO activity are getting close to 2007 peak levels, and it is hardly comforting that the smart money seems to be cashing in some chips.
We will concede that geopolitical flare ups have not derailed the rally yet. However, it is disconcerting that these events are becoming more frequent and the current administration consistently seems two or three steps behind even as president's golf handicap is improving. One cannot discount the possibility the market could be blindsided by a geopolitical landmine before the end of the year.
I think most investors are discounting the impacts of the end to the Fed's largesse which has been a significant tailwind for the market over the past five plus years. I also believe Europe is close to stall speed and would not be surprised to the market react negatively to another geopolitical flare up.
That being said, the market is not wildly overvalued at about 16 times this year's earnings estimates given the low level of interest rates. There are certainly pockets of overvaluation including some of the hot recent IPOs like El Pollo Loco (NASDAQ:LOCO) and even the Russell 2000, but the large blue chips of the market like Apple (NASDAQ:AAPL) or Gilead Sciences (NASDAQ:GILD) seem more than reasonably valued and should continue to head higher.
This is bifurcated market between overvalued momentum names like Tesla Motors (NASDAQ:TSLA) and reasonably valued core portfolio names like Boeing (NYSE:BA). I am tackling this in some obvious ways such as avoiding the high beta sectors of the market and keeping most of portfolio in more value orientated stocks.
In addition, I have a higher allocation than normal to cash (~25%). I have also sold just out of the money call options on most of my growth stocks, especially small caps. Finally, I am using just out of the money bull put spreads on new positions to pick up premium and/or pick up lower entry points. I have found this strategy works very well in a flattish to slightly down market, which is what I see is the most likely case for domestic equities for the rest of the year. That is my plan for the rest of 2014, what is yours?
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 (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.