Tuesday, June 24, 2014

The Positive Case for the U.S. Stock Market Revisited

We remain optimistic regarding prospects for the U.S. market, but with a more elevated level of caution.

Coming into the year, we forecasted 2014 U.S. GDP growth of about 3%, which we expected to result in Standard and Poor’s 500 (S&P 500) corporate profit growth of 7-9%. In a fairly valued but not overvalued market, we projected further that this profit growth would result in a corresponding 7-9% gain for the S&P 500 Index in 2014 (see Marietta’s Jan. 3 Outlook).

Since the beginning of the year:

  • The U.S. economy suffered from a weather-impacted -1.0% first quarter GDP setback, which has reduced the consensus (and our) 2014 GDP growth estimate to 2.4% (“The Economist” June 14, 2014).
  • The underperformance of the U.S. economy year-to-date has lowered corporate profit estimates for 2014.
  • Despite reduced 2014 economic growth and profit expectations, the S&P 500 Index has advanced 7.1% through June 23.
  • The fully-valued stock market is stretched further with corporate profit estimates coming down and the market moving up. Howard Silverblatt, S&P 500 Senior Index Analyst, reports that the consensus of Wall Street analysts estimate the forward P/E ratio of S&P 500 operating earnings to be 16.1x versus a 10-year historic average of 14.8x. Bloomberg (June 12) adds that 70% of S&P 500 stocks currently sport forward year P/E’s above this 10-year average, raising concerns for the market’s valuation.

We emphasize that there are many other factors influencing the market in addition to corporate profit gains and valuation. Among the offsetting positives are:

  • ┬áThe economy is rebounding from the first quarter downturn, as reflected in strong employment gains and healthy Purchasing Manager Indexes (PMI) for both manufacturing and services. The result could be a surprising boost in corporate earnings.
  • The Federal Reserve remains highly accommodative, further supporting the economy and financial markets.
  • Although 2014 profit estimates have been coming down, first quarter earnings were not as bad as the negative economic growth would suggest, and research analysts remain highly optimistic for the year as a whole. Deutsche Bank reports that although first quarter GDP was negative, S&P profits actually gained 5% (June 6 “U.S. Equity Insights”). During this difficult first quarter, 335 (67.3%) of S&P 500 companies beat Wall Street expectations. For all of 2014, Silverblatt notes that “bottom-up” consensus analyst profit growth estimates for the S&P 500 Index remains a lofty +11.5%. We remain comfortable that our +7-9% projections for both profit gains and market gains will be matched or exceeded.
  • With regard to valuation, we observe that the market’s P/E ratio historically has been higher in periods of low inflation and interest rates. Strategas research informs us that since 1950, the average P/E ratio in periods with 0-2% inflation is 17.9x, whereas 4-6% inflation is associated with an average P/E of 14.7x. This diminishes the concern that the market is currently unsustainably overvalued. Indeed, there is also the distinct possibility that there could be more market multiple expansion reflecting a continuation of 2013 trends.
  • Corporations are still sitting on a mountain of cash, which is being used to fund M&A activity, dividend increases, and stock buybacks, all of which elevate the overall market.
  • Stocks remain highly attractive relative to low- or zero-yielding money market and bond competitors. The Investment Company Institute (ICI) report for April shows $2.573 trillion on the sideline in money market funds that could help fuel a further stock market advance.

Our conclusion is that the positive case for stocks is still intact, but the rising valuation of the market increases its vulnerability to an economic or geopolitical surprise. Investors will need to be cautious and flexible.

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