With the Federal Reserve scheduled to meet Dec. 17-18, investors will be keeping a close eye on this week’s heavy assortment of economic reports. Will these reports be enough to spur the Fed to begin tapering before the end of 2013, and will that spark a major market sell-off? We will soon find out!
The Standard & Poor’s 500 Index gained 0.1 percent last week, setting another record close Wednesday and achieving its eighth-straight weekly gain. The index jumped 2.8 percent in November, ending the month with a 26.6 percent year-to-date gain.
The Dow Jones Industrial Average rose 3.5 percent in November with another record close Wednesday. The Nasdaq Composite added 1.7 percent for the week and 3.6 percent for November, finishing above 4,000 on Tuesday for the first time since September 2000.
This week will provide investors with several key economic releases, including Markit Economics’ manufacturing gauges for China, Japan, Germany and France (Sunday night and early Monday), as well as the Institute for Supply Management’s reading on U.S. manufacturing (due at 7 a.m. Pacific time Monday). Monthly auto sales reports will come Tuesday, a third-quarter U.S. gross-domestic productupdated on Thursday, and a consumer-sentiment reading on Friday.
We will also get our first reading on holiday sales from Black Friday and Cyber Monday, a key day for online holiday shopping. Early reports show that holiday shoppers plan to spend about the same amount as last year or more than last year, according to a Sterne Agee survey and a Deloitte poll.
The Labor Department’s Friday report on October nonfarm payrolls is expected to show an increase of 180,000 jobs. While this is certainly nothing to celebrate, it could be enough to nudge the Fed toward tapering sooner rather than later.
Most economists expect the Fed to wait until March to begin tapering. This delay into next year has provided relief from the mounting pressure we witnessed on interest rates earlier this year, when the 10-year treasury yield edged above 3 percent. Stocks reacted negatively to this move in rates, but rebounded and ran to new, all-time highs, once rates receded after the Fed indicated it would postpone tapering.
We have seen several high-profile companies experiencing double-digit, or at least very significant, declines after disappointing earnings reports. These have included Whole Foods, Tesla, Chevron, Royal Dutch Shell, Sony, Vertex, Yelp and Caterpillar. Even some of the more defensive names, such as Campbell’s Soup, have been pounded after disappointing financial reports.
Many others either met or even surpassed expectations, but still declined, or at minimum did not advance as would normally be the case if the overall market were not at such elevated valuation levels. Still, these declines were not enough to stifle the momentum of the overall market.
The S&P 500 is now trading at about 20X trailing earnings (based on actual as-reported earnings). In comparison, the index was at a 29X P/E multiple at the peak of the tech bubble in 2000. Trailing earnings are not the most accurate way to judge the valuation of the stock market, however. Stocks trade on future expectations of earnings, which are largely influenced by analyst forecasts.
The long-term historical average P/E for the S&P 500 is 16X, so the current 20X is significantly higher (+25 percent). Looking ahead, 2014 as-reported earnings are expected to be about $108, which would give the S&P 500 a forward P/E of 16.7X — a bit above the historical average of 16X, but not dramatically so. The real question is: Is the $108 earnings estimate realistic?
The problem we will have with earnings as we move into 2014 (and beyond) is that companies have been making their quarters, not by growing revenues, but by cutting costs, including cutting employees. We are now five years into the recovery for the U.S. economy, so companies have exhausted just about every possible way to cut costs. Going forward, if they want to grow earnings, companies must grow revenues. Easier said than done!
The economy is growing at about 2 percent annually. Further, employment growth has been very sluggish (which is why the Fed continues to pump $85 billion each month into bond purchases to try to stimulate the economy so companies can hire people). But companies are not hiring, and in fact have been laying off people in alarming numbers.
To grow S&P 500 earnings to $108 from the current trailing number of $91, or by 19 percent, companies must grow revenues significantly over the coming year. Revenue growth comes from just one place — spending. Since consumer spending accounts for about 70 percent of total GDP growth, it will be consumers who either make or break economic growth and therefore corporate earnings. Unless we see unemployment drop substantially from the current 7.3 percent, it is difficult to imagine that corporate earnings could grow by 19 percent in the next year.
In the near-term, stocks do appear to be overvalued. We are currently at all-time highs for the S&P 500 and the Dow Jones Industrial Average, and at a 13-plus year high for the technology-heavy NASDAQ Composite Index. Any disappointing data on the economy could be enough to trigger a 10 percent or greater correction in stocks. Corrections of this magnitude are quite common during bull market periods (we have already experienced several since the lows set in 2009). Any indication of a move by the Fed to taper off its bond-buying program before March could send stocks significantly lower.
Often, when stocks are expensive, just about anything can trigger a sell-off. With the added wrinkle of the risk of Fed tapering, both good and bad economic news could serve as that trigger. Good news, especially employment gains, could indicate that the Fed will taper sooner, while bad economic news can be interpreted to mean that future earnings will be weak.
With all this stated, the reality is that stocks have been in a strong up-trend for more than a year. Global GDP is about 30 percent higher today than it was at the peak of the economic cycle in 2007, before the financial markets imploded in 2008 and the economy entered the Great Recession. At the peak, the S&P 500 set a record high close of 1,565 in 2007. Adding 30 percent to that value would place the S&P 500 at a potential peak of 2,035, which would represent an additional 13 percent gain from the current level of the index.
It’s difficult to know where the rally will end and, when it ends, if the market will experience a significant sell-off, or simply stagnate but hold its ground. If history is any guide, we should expect an increasing level of volatility as the level of the index increases, which would mean more significant corrections, even as the bull market continues.