"When Wall Street sneezes, the rest of the world catches pneumonia." This is how the old saying goes. Looking at the recent trends of world economy and of equity markets, investors must hope that Wall Street and the US economy remain healthy. Indeed, a slowing US economy and/or a decline on Wall Street could have negative repercussions on an already fragile international economy.
Fortunately, we think that the short-term outlook for the S&P 500 remains positive despite some profit taking in the short term is possible following the record high set on Monday 8th.
We think that US equity markets could benefit from the positive economic scenario. All the latest economic data indicated that the US economy could grow at 2/2.5% in H2 '16. With the US equity markets used to post negative performance during recessions, signs of economic slowdown could force investors to liquidate positions. For this reason, business confidence indices and initial jobless claims are the most important data to monitor.
The low level of inflation (in June CPI was at 1% y/y and CPI core at 2.3% y/y) is also positive for the equity markets. Unless there's a strong and unexpected increase in inflation, the Fed should maintain an expansionary monetary policy for the time being. Indeed, even in the case of a 25bp rate hike in September or in December, Fed monetary policy would remain expansive according to the most used monetary policy rules (i.e. according to the Taylor rule, the Fed Fund rate should be at 3.45%). In this scenario, the 10-year government bond yield will hardly rise above 2%. In this scenario, investors should continue to consider interesting the 2.1% dividend yield of the S&P 500.
Market indicators also depict a positive picture for Wall Street.
First, the NYSE A/D line of the NYSE, calculated by taking the difference between the number of advancing/declining stocks and adding the result to the previous period's value, remains in a clear upward trend, in line with the continuation of a positive trend for the equity market as signaled by the following chart.
Only a decline below the 200-day moving average would represent the signal of a trend reversal. Main trend and momentum indicators, such as the moving average to 200 days or the 12-month momentum, also continue to indicate an upward trend.
In this scenario, the S&P 500 trend should remain positive and any decline should be considered a buying opportunity. Only a decline of the ISM manufacturing index below 50 or a jump above 300k of the initial jobless claims - signs of rising possibility of recession in the months ahead - or a decline of the S&P 500 below 2040 could mark the beginning of a downtrend.
At the same time, we think that the upside potential of the S&P 500 is limited.
According to data collected by FactSet, the P/E of the S&P 500 is now at 17x, well above the last 10-year average of 14.3x. For this reason, a new P/E multiple expansion seems unlikely. The performance of the S&P 500 should thus be dependent on the trend of earnings. However, the latest earnings season showed the fifth consecutive decline of profits.
According to consensus estimates, profit growth should turn positive in Q4 '16. However, both profit margins and government bond yields anticipate a barely positive growth rate of profits over the next 3/5 years. In this scenario, we expect moderate returns of the S&P 500 over the next few years.
Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.