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The Upcoming Quarter:
With signs that the U.S. economy is recovering from a winter contraction and the Federal Reserve expected to keep interest rates low for at least another year, many investors are betting the five-year bull market has more room to run. They are reluctant bulls, however, seeing few alternatives to equities. Investors are confined to stocks because money-market funds don’t pay anything and bond yields are so low.
A strong June employment report eased fears that economic growth was just making up lost ground due to the terrible winter. Since late last year, the Federal Reserve has been gradually reducing the amount of long-term Treasuries and agency mortgage backed securities it buys from the market and hence, reducing the degree of monetary stimulus. This so-called tapering of quantitative easing progressed steadily throughout the mini-slowdown, and there is no indication that the course will be altered now that economic activity has picked up. Given that the current rate of asset purchases totals $35 billion per month and this is reduced $10 billion each meeting, it is highly likely that this easing will end by the fall. The attention of the Fed will then turn to interest rate increases.
Regardless of the timing of the first interest rate hike next year, it is highly likely that short-term interest rates will stay below historical norms of 2-3% for an extended period.
Investors have been holding back putting new money into the market for fear of buying at market highs and then seeing a large market drop. The Dow has seen 14 record closes this year but waiting for a significant drop to buy has not worked out as the Dow hasn’t dropped more than 10% in nearly three years. Volatility remains relatively low. The S&P 500 hasn’t closed up or down more than 1% since April 16th.
As often is the case, prospects for the rest of the year are dependent of how second quarter earnings season shakes out. S&P stocks are forecast to show a 4.9% rise in second-quarter earnings per share from the previous year. While that still would fall short of the 8.6% growth in the fourth quarter of 2013, it would outpace the 2.1% increase posted in the first quarter of this year. For the rest of the year, Wall Street analysts’ outlook is even rosier calling for profits to increase at their fastest pace since 2011.
The S&P rally of last year left many stocks on the pricey side of long-term averages relative to their profits. The S&P 500 is trading at a price/earnings ratio of 15.6%. Nevertheless, this is actually down from the previous quarter. In addition the U.S. stock market has high exposure to sectors with consistently higher P/Es. U.S. corporate profitability remains high, amid rising cyclical productivity, muted input cost inflation, and low debt-service obligation. All-in-all we expect the market to continue to move upward in the third quarter.
Bruce A. Kraig, MBA, CFP
July 2014
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