According to the Fed’s long-term plan, quantitative easing (QE) was to remain in effect until the economy was strong enough to grow on its own. This was the so-called anticipated “handoff” whereby a strengthening economy would take over from QE as the catalyst for growth. The problem is that it is not quite happening that way. With QE encountering diminishing results along with increasing unwanted side effects, it is gradually being withdrawn at a time when it appears that the economy has still not broken out of its approximate 2% growth trend. In addition, the stock market is facing numerous other headwinds including high valuations, excessively bullish sentiment, stagnant economies in Europe, a slowdown in China, and currency problems in many emerging markets. All in all, this does not bode well for the stock market in the year ahead. A brief summary of the various headwinds are as follows.
The perceived strength of the economy in the 2nd half of 2013 was not soundly based and is unsustainable. A large part of the growth was a result of unwanted inventory increases and foreign trade. In addition the rise in consumer spending was mostly financed by a decreased saving rate while disposable income continued to languish. In seems likely that growth, at best, remains in the 2% range, and even that is subject to disappointment without QE, and with all of the other problems throughout the world.
Contrary to the consensus view, we believe that the market is significantly overvalued. The majority are looking for 2014 S&P 500 operating earnings of $US120, resulting in a P/E of 14.8, supposedly in line with past norms. However, the long-term P/E average of about 15 is based on reported (GAAP) trailing earnings rather than forward-looking operating earnings. Profit margins are about 70% above the long-term average, and are likely to return to the mean. As calculated by Ned Davis Research, cyclically smoothed earnings for 2014 are about $US81, resulting in a P/E of 21.9, a full 46% higher than the long-term average. We note, too, that the forward-looking P/E in late 2007 was about the same as it is now, and did not preclude a 50% drop in the market. Furthermore, the ratio of total market value to GDP is the highest of any time in the post-war period with the exception of the late 1990s internet bubble.
Bullish sentiment is historically high. The Investor’s Intelligence Survey shows the highest percentage of bulls in 25 years, while margin debt as a percentage of GDP is the highest ever. Anecdotally, market opinion going into this year was almost unanimously bullish.
The withdrawal of QE is negative for stocks. The market soared on the implementation of QE1, and declined when it ended. The same happened with QE2. The market again rose at the start of QE3. The ending of QE is tantamount to tightening, and that is not good for stocks.
China’s economy is slowing down at a time when it also has severe credit problems that restricts its options. The slowdown puts downward pressure on global commodities that are the major exports of emerging nations, which are also undergoing significant currency problems caused by an outflow of funds. A worldwide economic slowdown or recession is likely to create headwinds for the U.S. as well.
All in all, the market looks a lot like it did in early 2000 and late 2007 when the consensus was also uniformly optimistic and valuations were stretched on the high side. In our view the risk of a substantial market decline is high.
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