ConvergEx Chief Market Strategist Nick Colas: Stocks, Earnings Up 8%/Year In '15, '16 If Low Volatility

Includes: DIA, IWM, QQQ, SPY
by: Harlan Levy


GDP up 2.5% in Q3, 4, long slog recovery in '15.

If low volatility continues stocks, earnings up 8% in '15, '16.

25-basis point rate hikes start in Q1 or Q2 '15.

New jobs: 250,000-300,000/month rest of '14, but not good jobs.

Nicholas Colas is a managing director and chief market strategist at brokerage ConvergEx Group. Previously he worked in equity research at Rochdale Securities and investment bank Credit Suisse First Boston.

Harlan Levy: What do the mixed data on consumer confidence, personal income, consumer spending, and initial jobless claims tell you about the economy?

Nicholas Colas: The most recent data showed that consumer spending dropped 0.1 percent in July, and that's the first decline since January, and June was a lot better.

Consumer spending has been a problem for this recovery in many different ways. Consumers are 70 percent of the U.S. economy, and it's important that they continue. It's been very choppy this recovery over the last five years.

The flip side is that we also got a very good consumer confidence number from the University of Michigan, coming in at 82.5, beating expectations and better than in July.

So we have a bit of a mixed story on consumers. On the one hand they seem to feel OK if you ask them about confidence. They seem to answer positively. At the same time they're not really voting with their pocketbooks.

Q: So what does that say about the strength of the economy?

A: The best way to characterize the economy is that it's doing modestly better. It's still not a robust recovery. We had a very choppy first half of the year, and it seems to be getting a bit better. The jobs picture is improving to some degree, and overall growth seems to be tracking to a 2.5 percent Gross Domestic Product growth rate.

Q: The second quarter GDP growth was revised up to 4.2 percent, which sounds like good news, but isn't it mainly businesses and not individuals doing well, and isn't that a problem?

A: The classic issue at this point in the recovery is having business expansion that matches the consumer, because if businesses build a lot of inventory, and the consumer doesn't show up to buy the inventory, then that's when you have the basis for the next recession. If businesses overspend, overproduce, and consumers are not ready to take the output then you get an inventory correction. So it's very important that you don't see inventory levels rise in the back half of the year.

Q: So what do you expect GDP to do in the second half?

A: I expect GDP is going to grow 2.5 percent in each of the next two quarters in a fairly stable fashion.

Q: Initial jobless claims have dipped a lot. What do you think the August new-job total will be, when it's announced Friday?

A: To put it in context, the last initial job claims number was 298,000, and that's some of the lowest observations that we've seen for initial claims adjusted for population growth. So the labor market is clearly improving, and I expect we'll see job growth between 250,000 and 300,000 every month through the balance of the year.

Q: But the jobs aren't good jobs.

A: That's the problem. Job growth has not been on the good side. It's been lower-income jobs, jobs at the minimum wage or a little bit better, jobs in retail, jobs in leisure, restaurant jobs. It has not been a great recovery in terms of the quality of jobs.

It is very consistent of the general tenor of the recovery, which has been, "Yes, we've had a recovery, but no, it has not been particularly robust."

Q: Will that continue next year?

A: Unfortunately, I think the answer is yes. This is the kind of recovery that seems to be able to generate what basically is still simply a long slog out of the recession. I don't expect it will pick up materially next year and will continue along the same general path.

Q: Is inflation becoming a factor?

A: It depends on how you interpret the term "inflation." If you think of inflation as the cost of living, then the cost of living has certainly been going up, because food prices are going up. You have offsetting lower gasoline prices, but food prices have definitely gone up. The cost of living is absolutely rising, and it's rising more than the stated 2 percent rate of inflation that the Federal Reserve uses.

If you talk about inflation like an economist, then there's very little risk of inflation.

Q: We know the Fed looks at inflation and other factors to decide when to raise interest rates. When might that happen?

A: The Fed should begin to raise rates in the first or second quarter of next year. They've told us that general game plan, and unless something really goes wrong they'll do it before next summer.

I don't expect that the Fed will be especially aggressive. When people hear the phrase "interest rate cycle," they tend to think back to 1994, when the Federal Reserve was very aggressive in raising rates during that cycle. But I don't think the Fed will be anywhere nearly as aggressive this time around.

There'll be a slow series of 25 basis-point increases in the fed funds rate, not the 50s when we look back at ’1994. This will be a long slow cycle.

Given where longer-term interest rates are right now, signaling very slow growth and no chance of strong inflation, I don't think that the first moves will be especially traumatic to the market. This has been well telegraphed, well explained. It shouldn't create a big shock.

Q: Can stocks continue to advance short of a geopolitical military shock?

A: We've had a fantastic five-year run in stocks. I think the best you can say about U.S. stocks currently is that they're fairly valued and will grow as earnings grow. So if earnings growth will be 8 to 10 percent over the next year, then the stock market should rise by the same amount. We're not going to get a lot more valuation bump in this market. We've had a lot of it, but that game is basically over.

Now, it's a matter of growing earnings to make the stock market increase in value.

Q: So do you expect 8 to 10 percent increases?

A: I'm thinking that's a reasonable expectation in each of the next two years. If I had to put a pin in it, it will be closer to 8 percent, because we're not going to get much better than 8 percent GDP growth in each of the next two years.

Q: What about the geopolitical factor?

A: I'll make two observations: First is that the stock market only does one thing. It discounts future cash flows of public companies. It's not a referendum on the popularity of presidents, and it's not a voting system on the stability of the global political system. So you have to put it in context. The stock market just does one thing.

What we have right now is a very unique situation where Europe, which is still the largest economy in the world, is being pushed into another recession by worries over its energy supplies from Russia and worries about deflation at home.

Against that backdrop it's going to be tough to generate a lot of earnings from Europe, so big multinational companies will have a real challenge. The benefit is that it keeps energy prices very low.

The other issue we have is the Middle East, and, again, it's a unique situation. It used to be that terrorist organizations wanted to cut off the supply of oil to the U.S. and create geopolitical tension. ISIS is totally unique. They're happy to pump oil to anybody and sell it to anybody to fund their operations. So you're not getting that cutoff of oil supplies from the Middle East, which has been in general the gist of what has increased oil prices in past crises and created recessions. But you don't have that this time.

Q: How worried are you about this?

A: My worry that the problems in the Middle East filter back to Europe and filter back to the U.S. in the form of Jhadis returning to their home countries to wreak havoc here. I worry about that. If they're contained in that region, then it's not currently that large a concern. It's horrible for the people who live there, but in terms of the narrow perspective of the capital markets it's not a big issue.

Q: What's your biggest worry in general?

A: I have two. The first is simply that we're so used to low volatility, and so many of the models that investors use to manage money are anchored on low volatility, that if we do get a volatility shock or if volatility simply starts to trend higher nobody is set up to accommodate it, and you get a very difficult situation in capital markets, because everything we've done in the last three years has been largely anchored around a VIX that's 10 to 15, not 20 to 30. That includes how people trade using computers. That includes market structure. That's my single biggest concern. We've built a system now that needs low volatility to operate.

My second worry is about a geopolitical shock. There is such unprecedented amounts of money flowing into the Middle East for arms and conflicts. In many ways it’s never been this bad, because with every prior crisis - Saudi Arabia in 1973, Iran in 1979 - you'’re talking about state actors. Saudi Arabia was about Israel. Iran was about their revolution, and in both cases you had state actors that had state diplomacy to rely on, or, in the case of Iran, you just had a long period of time when Iran has not been part of the global community.

In this particular case you have huge amounts of money, hundreds of millions of dollars flowing into a region of conflict, and there are no state actors in the front lines. It's new groups that have different agendas from the way a government operates. We've never seen this before.

This is a brand-new paradigm. You heard the president describe it pretty well. It requires a real "re-think" of how you deal with the Middle East, because it’s not longer working with a government in Baghdad or even Tehran. This is about how you deal with an organization that is generating huge amounts of cash flow in very quick fashion, and it wasn't even a factor a year ago. Now it controls a very large amount of territory. These are brand-new challenges, and I don't say that lightly. There's not a lot that's brand-new. This is brand new.

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.