The rally since March 2009 has been a long train running. But this year the train has hardly left the station. Big trends can take a long time to reverse. And (unfortunately for bulls) when a major trend changes after a flattening-out period, the market tends to break in the opposite direction from the formerly prevailing trend.
For most people now trading the market, the most significant extended trend change occurred in 2000. After running from early 1995 to early 2000, the great 1990s bull finally stalled in March of that year, with the S&P 500 in the 1,500s. Investors back then were so desperate to believe the over-valuation party could go on indefinitely that the S&P 500 mainly range-traded near its highs across most of winter, spring and early summer 2000. But in August 2000, with the S&P 500 still in the 1,500s, the market embarked on extended move lower through October 2002, in a world still reeling from 9/11.
Does that mean the break-out of this stasis will be downward? Not necessarily. A static stock market can go a long way to working down perceived or actual overvaluation, particularly if the prior market has run ahead of earnings (as it did during 2012 and 2013) and the current market is standing still while earnings are still growing (as is now occurring). Even after a five-year bull market, today's valuations are okay; whereas in 2000, valuations were stratospheric, and about to get worse as earnings dissolved in a politically turbulent world.
Granted, Q1 '14 GDP was weak; but the monthly data seem to argue for a snapback in 2Q14. And earnings are growing better now than they were in the past two years. We are standing by our forecast for high-single-digit to low-double-digit stock-market appreciation in 2014 based on strong underlying economic and earnings fundamentals.
The Economy, Interest Rates, and Earnings
The first or advance reading on Q1 '14 GDP missed our already low expectations. We could see this number nudged higher from the advance 0.1% reading in the preliminary and final reports, particularly given the increase in jobs and the labor force. But mainly we are looking for a second-quarter rebound in GDP growth, given across the board strength in economic data from March and April. We continue to model high 2% and possibly even low 3% growth in 2103, particularly in the back half of the year. But our expectations for first-half GDP - a weak Q1, a sharply stronger Q2 - make the full-year forecast somewhat murky.
One key element of our growth forecast is the accelerating trend in employment. In addition to the accelerating three-month rolling average in nonfarm payrolls, the US labor force grew by 1.29 million in 1Q14, a 14-year high, as more Americans look for work. Jobs growth and labor participation should feed consumer spending, which we expect to rise better than 3% in 2014. After a weather-slammed January, almost all retail categories recovered in February and surged in March and April. Also in the consumer category, we expect normal seasonal strength in housing. Within the industrial economy, durable and capital goods orders show signs of rebounding from year-end weakness. Capacity utilization has recovered to its long-term average, which along with rising intermediate-stage PPI has led to concerns about incipient inflation.
The Fed is cognizant of those concerns, even if they are very early days. Looking ahead to 2015, Argus is modeling 3.1% GDP growth in our initial forecast for next year. We look for a strong start to 2015 as the economy should be firing on all gears but without the restrictive impact of higher short-term rates. Beginning in mid-2015, we look for the Federal Reserve to begin boosting the fed funds rate at a measured pace. We are therefore modeling slightly faster GDP growth in the first half of 2015 than in the second half. Government spending may be at an inflection point. Looking ahead, we expect the declines in federal spending to narrow in 2014, and believe both federal and state & local spending could be contributive to GDP in 2015.
Across the yield curve, yields are slightly lower than they were one month ago. But the pace of decline has slowed, and after four months in which bond prices strengthened and yields declined - bonds now seem to be struggling for direction. Bond yields are lower than they were one month ago but higher than they were one week ago.
The Fed has not tightened monetary policy via a hike in the fed funds rate since the middle of the last decade, or 2006. Fed Chair Janet Yellen's thresholds for more restrictive policy include an unemployment rate below 6% along with inflation growth above 2%. We think better than expected economic growth will surprise the market and the Fed. Argus forecasts that the 2% inflation target could be surpassed within one year, and unemployment could fall below 6% sooner than that. Rising inflation and declining unemployment would pressure the Fed to conclude QE and consider raising rates sometime next year.
Year-to-date performance in the bond market reflects the more defensive cast to the equity market this year, as well as the wave pattern within long-term trends. After the doubling in long-term yields over the second half of 2013, there has been a predictable retrace - but not nearly to past lows. The bond market has undergone a major trend change in the past 12 months. While long rates are not where we thought they would be by now, we note that the yield curve remains steep, meaning bond investors continue to anticipate an expanding economy. Our outlook for the short-end of the curve is unchanged; we do not expect the Fed to begin hiking rates before mid-2015. Elsewhere along the curve, we would expect a gradual rise in rates across 2014 consistent with a slowly expanding economy.
One month ago, we offered our revised Q1 '14 EPS estimate of 6.2% growth, much higher than the 1% forecast by the consensus for S&P 500 earnings growth in the first quarter. With 83% of S&P 500 companies having reported results as of late last week, calendar Q1 '14 earnings had grown 7.6% year over year on a market-cap-weighted basis and 9.6% on a non-weighted basis from the first quarter of 2013.
Companies providing guidance are inherently and understandably cautious. That's a formula for the Street to underestimate earnings, and that is what has happened across most quarters during this bull market. But we were particularly encouraged that calendar Q1 results exceeded our expectations, given weather-related impacts but also based on our concerns that weakness in housing and durables spending reflected some consumer exhaustion.
We view the deep-winter slowdown as a pause rather than as the beginning of a reversal in trend. Housing is still well below its historical contribution to GDP. And job growth appears to be accelerating, with growth in March and April non-farm payrolls coming in higher than the three-month and six-month averages.
Earlier this year, Argus Chief Investment Strategist Peter Canelo introduced his preliminary EPS forecast for 2015. Off the estimated 2014 base, Peter is modeling 6% growth in continuing operations earnings, to $127.25, for 2015, without yet providing a quarter by quarter break-out. Our 2015 estimate is below consensus, although we note that the 2015 consensus is thin so far. In our view, as the Fed begins to raise interest rates, economic activity could be impacted by the rising cost of doing business. We will therefore be slow to hike our 2015 EPS estimate, unless actual 2014 earnings blow expectations out of the water.
Foreign Markets and Domestic Sectors & Indices
Let's now move to our index and sector performance -- as a reminder, the data was captured earlier and typically reflects the end of the prior week's data.
The trend shift between bonds and stocks has been significant. For the first time in over two years, the Lehman US Aggregate Bond index is outperforming all of our equity indexes. Strength in bonds this year reflects lots of forces: geopolitical tensions courtesy Mr. Putin, concerns that stocks are overvalued after last year's run, a sense that the spike in bond yields in 2H13 as too much too fast. Particularly given the first whiffs of inflation in the PPI numbers, investors may be pricing in future rate hikes by the Fed.
Within equities, the most dramatic contrast is between growth, down year to date, and value, up year to date. This trend was partly visible in 2H13. But as headline growth stocks have crashed and failed to rebound, the performance gap between growth and value has broadened to 690 bps.
The market continues to favor blue chip over small-cap; the S&P 500 is up 2.2%, whereas the Russell 2000 is down over 5%. Lack of sector diversity may be holding back the DJIA. Despite hitting new all-time highs, the Dow lags the S&P 500 year to date because of a dearth of utilities and the "wrong" (non-trending) names in healthcare and energy.
Investors are aware that there is now a cautious and even defensive tone in the market in 2014. This is much different than it was one year ago, when investors were in rally mode. The crash in high-profile names may make it seem as though the market has changed profoundly. Yet on a year over year basis, the changes in sector weightings reflect not a defensive shift, but a continued swing into economy-sensitive and growth areas.
On a year over year basis, the sectors that have added the most market weight are industrial (up 80 bps), technology (up 60 bps), and healthcare (up 50 bps). Utilities, which are a market leading sector in 2014, are actually a smaller component of S&P 500 weight than they were one year ago. That's because the great change in interest rate thinking began late in May 2013. Utilities crashed in the second half of 2013; and their strong showing in 2014 is at least partly a phoenix-like rise out the ashes of 2H13.
The most significant year over year downsizing has been in consumer staples, which declined from an 11% weighting one year ago to 9.9% at present. The annual trend change in utilities and staples argues that the swing to defensive is a very recent phenomenon.
On a month-over-month basis, we have seen a backing-off in economy-sensitive sectors (financials, discretionary, technology) and recovery in those defensive areas of Utilities and Staples. But the biggest monthly mover by far has been in energy. We think the relative strength in energy has some economic components: the global recovery is ongoing. But the global recovery has been ongoing for several years, and during most of the recovery energy has lagged. What has changed has been the awakening of inflation fears, and the growing preference for wealth in the ground as a hedge against potential pricing pressures.
Given this year-long perspective, we would be cautious about drawing conclusions from year to date sector performance. Specifically, the rally in defensive names year to date could be something of a head fake. At least partly, defensive outperformance in 1H14 represents recovery off a weak 2H13, when the second half strength in economy-sensitive names coincided with a crash in defensive names.
Compared with one month ago, three sectors - Healthcare, Consumer Discretionary, and Financials - have retraced by about 200 bps. Technology is down slightly less than the market. The lag in these economy-sensitive sectors was offset by two themes: continued defensive rotation, and early inflation rotation. On the defensive side, Telecom and Utilities - two high-yielding sectors - were big winners. Staples also had a nice move higher, which may have been as much about value investing as defensive positioning.
The best single-month gain was in energy, up 540 bps from where it was one month ago. Materials, another inflation-sensitive category, was up 100 bps - even though gold remains in the bearish trend visible since the mid-March 2014 recovery highs.
Compared with one year ago, Defensive and Inflation-sensitive have best held their value. Materials, Energy, and Utilities are currently within single digits of where they were one year ago in year-to-date 2013. Economy sensitive areas have significantly rotated away from last year's leadership.
While the overall overseas market picture remains mixed, we have seen some notable changes year to date. Compared with one year ago, India is in favor, and Japan is out of favor. Investors prefer Europe over Asia, a very notable change relative to the past few years.
Generally, foreign markets are down, though improved month over month. Year to date, our basket of 11 foreign markets is down 0.6%; a month ago, our basket was down 4.3%. Among hard-currency nations, Canada leads with an 8% gain. The disconnect within BRIC remains pronounced, although the split this time is not along the usual fault line of resource economy (Brazil & Russia) vs. non-resource economy (China & India). India and Brazil are positive year to date, while China and Russia are down.
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.