Market Commentary

by Byron Wien

07/28/2014

Challenges to the Positive Outlook

Since the beginning of the year, I have believed that the second half of 2014 would be positive for both the economies and the equity markets of the developed world. Like many, I was surprised by the weak first quarter in the United States – real Gross Domestic Product (GDP) was -2.9% – but I viewed that as a kind of mini-recession within an ongoing recovery and attributed it to severe weather conditions, accounting issues related to the Affordable Care Act and other factors. I expected that the following quarters would exhibit renewed momentum based on the economic data being reported.

Almost every indicator I am now looking at is, in fact, showing a better tone to the economy. Vehicle production is running at 17 million units; consumer confidence and retail sales are improving; bank loans, which indicate a willingness by business people to borrow for inventories or new projects, are strong; capital spending is picking up; new plants are being planned or built; the unemployment rate is down to 6.1%; and the number of jobs created in June was impressive. In addition, initial unemployment claims are down, small business hiring plans are positive and there are signs of wage increases in the service sector. Based on historical trends, we will not have to worry about wage acceleration until the unemployment rate hits 5.5%, which probably will not happen before sometime next year.

On the other hand, the indicators are not universally positive. Housing starts, which had been running above one million units, dropped to 893,000 in June. Building permits also declined. For the economy to move toward 3% real growth in the second .half and for unemployment to continue heading to lower levels, housing has to be strong. Recent data on housing has been mixed and the drop in starts is troubling, but there are enough other positive signs that I am not altering my favorable forecast. If housing continues to be weak, I will probably have to change my view.

There were certain other negative signs, however, and these might explain why the market seems reluctant to move higher. The first is sentiment. Most investors are optimistic or complacent. The Ned Davis Research Crowd Sentiment Poll, which I have found helpful in the past, is extremely positive, and we all know that the best time to buy stocks is when most investors are negative. This doesn’t mean that the market cannot rise further, but it is a warning sign that a correction could occur before the next meaningful advance. In contrast, a Bloomberg Global Poll found 47% of the respondents thinking the market is close to a bubble, with 14% saying we are already in one. This level of caution among the investment professionals who are Bloomberg subscribers is encouraging as a contrary indicator. The seasonals are also against the market. The summer is usually a difficult period, and in mid-term election years the Standard & Poor’s 500 has suffered an average decline of 3.1% versus a gain of .7% for all years since 1950. Another problem is the age of the market cycle. The average bull market usually lasts 57 months, according to Strategas Research, and appreciates 160%. The S&P 500 has risen 186% in the 61 months since the March 9, 2009 low. It has also been a long time since we have had a meaningful correction: about 700 days since a decline

of 10% and almost twice as long since a drop of 20%. This is not unprecedented. In the 1990s the S&P 500 continued rising for 1700 days before a 10% pullback and over 3000 days before one of 20%. The rise prior to the 2008 decline extended for 1100 days before a 10% correction.

The market cannot go up forever. The question is, when will the pullback take place? Expansive Federal Reserve policy has helped the recovery, but now the Fed is tapering and investors are worried about an increase in short-term interest rates sometime next year. Recently, Janet Yellen, the Fed Chairman, has sent some mixed signals on future policy. She told the Senate Banking Committee that “a high degree of monetary accommodation remains appropriate.” She cautioned, however, that “if labor market conditions improve more quickly than anticipated, then increases in the Federal Funds rate target likely would occur sooner and be more rapid than currently envisioned.” She also chose to make some comments on the stock market. She implied that social media and biotechnology stocks seemed excessively priced but said the overall market did not appear to be overvalued from a historical viewpoint.

Many investors are worried about a shift in Federal Reserve policy triggering a serious correction in the market. Based on Chairman Yellen’s comments on the economy, I do not think an increase in short-term rates is imminent, but if GDP growth looks like it will exceed 3% real sometime in the second half, a rate hike is possible. My own view is that we won’t see a rise in rates until mid-2015. Ned Davis Research has done a study of market responses to the first increase in interest rates by the Fed. It shows that the S&P 500 does, indeed, have a sharp negative reaction, usually about 5%, but then continues to move higher afterwards. The danger of a change in the inflation outlook could be one reason the Fed would consider raising rates, but that doesn’t seem about to happen. Not only are wages increasing modestly, but commodity prices have softened. I think inflation will remain reasonably tame, and we won’t need to worry about it until sometime in 2015

Finally, the International Monetary Fund has reduced its estimate for World GDP real growth to a little more than 2%. It was 4% in 2010 and comfortably above 2% until recently. There is a general perception that growth around the world is slowing. Over the past month, however, better economic news has come out of China, indicating that the growth target of 7.5% will be reached. It appears, however, that an expansion of credit for spending on infrastructure and state-owned enterprises rather than consumer purchases is responsible for this. The rebalancing of the economy continues to be deferred. Offsetting the China news, European data is somewhat softer.

There also has to be an impact on the markets from geopolitical turmoil. The situation in Ukraine attracted world-wide attention when a Malaysian airliner carrying more than 300 people was shot down. The missile was Russian-made and almost certainly fired by the separatists, but Vladimir Putin has tried, unsuccessfully in my opinion, to shift the blame to Ukraine itself. While Putin wants conditions in the region to remain unstable, I think he will restrain the rebels for a period until world attention shifts to other issues. As a result of the incident, sanctions against Russia will be

intensified. I think Putin will wait until next year before making his next important move in the region.

In Gaza, Israel will continue to make every effort to locate and destroy the missiles that are being hurled into their country. Hopefully, the continuing escalation of civilian casualties will soon be halted by a ceasefire. There are two issues at the foundation of this crisis. Hamas lacks the money to pay its 43,000 civil servants and it wants to open the border with Egypt. These problems could have been solved, but Israel opposed American recognition of the transfer of Gaza control to the Palestinian Authority under the April 2014 reconciliation agreement and that essentially set off the current hostility. We will see whether bloodshed or diplomacy resolves the apparent impasse.

Elsewhere in the Middle East, I believe Iraq will eventually be divided into three tribal regions. Iran will agree to reduce its nuclear weapons development program. There is too much pressure from the younger people there to have the sanctions lifted so they can begin to take advantage of the opportunities they see open to their counterparts in other parts of the world. The current talks seem to be moving in that direction, but the July 20th deadline has been extended until the fall. The U.N. nuclear agency has said that Iran has converted all of its 20% enriched uranium into harmless forms, a favorable sign. In Asia, China will attempt to settle disputes in the South China Sea peacefully. Each of these trouble spots could erupt into something more serious at any time, resulting in a possible increase in oil prices or a challenge to the present world order that would be unsettling to the financial markets.

One of the problems limiting investor enthusiasm may be valuation. If the S&P 500 earns $115 in 2014, it is selling at 17.1x earnings. Market peaks have occurred historically at 25x–30x times earnings. On that basis, the market is fairly valued but not exceedingly expensive. The average trailing 12-month price-earnings ratio when the inflation rate is 0%–4% is 17. Recently a number of strategists have moved their 2014 estimates higher, but companies providing guidance to analysts have been cautioning them to be conservative, so I am not raising my forecast. If the economy grows at a rate of 3% real during the remainder of the year and inflation is 2%, then nominal growth should be 5%. With productivity increases continuing and share buybacks, the S&P 500 should be able to show improvement of 7% over the $108 in operating earnings of 2013 and that would put us at $115. With considerable cash on corporate balance sheets, share buybacks should continue. Therefore, if earnings reach my target and the S&P 500 sells at 20x, we could reach 2300, which is 17% above the present level or more than 20% above the index price at the start of 2014. Very few investors see that as a possibility because the market did so well in 2012 and 2013 and strong previous performance breeds caution about the future. Actually, strong market performance in a given year should not discourage investors about the outlook for the following year. When the S&P 500 has been up 25% or more, the next year is usually positive and has been in every such year since 1990.

The bursting of the technology bubble in 2000 and the sharp decline in the overall market that followed caused many fiduciaries to rethink their asset allocation. Money flowed out of equity mutual funds and into bond funds throughout the first decade of the new millennium. In 2002 endowments had 50% of their portfolios in equities; by 2013 it was down to 34%. Fixed income suffered as well, declining from 23% to 10%. The money went into alternatives, which increased from 24% to 53%. I know many institutions are rethinking this strategy now, and that could sustain the rise in equities.

Finally, taking a look at the economies around the world is probably useful. The United States is growing at 2%–3% real, Europe at 1% and Japan at 1.5%. The emerging nations are growing faster, but their markets are generally not responding although there are some good values to be found there. The U.S. market is large, liquid, transparent and, in my opinion, not overvalued. Stocks are attractive on a multiple basis compared to housing and bonds. I think interest rates are likely to remain low for longer than most people believe and equities may perform well for longer as well.

I continue to believe that real economic growth in the United States will move toward 3% during 2014, and S&P 500 profits will be up 7%, with a similar increase next year. As a result I believe the S&P 500 will appreciate in the mid-teens this year. One condition that gives me pause, however, is the disappointing increase in revenues, which were only up 3% in the second quarter. At this point they should be growing 4%–5%. I see neither a recession nor a bear market in sight even though we

are five years into the economic and market recovery. Let’s hope geopolitical turbulence doesn’t upset that outlook.

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