By: David Sterman of Street Authority
When the Federal Reserve first suggested a gradual tightening of its monetary policy in May 2013, investors began to wonder if the long-running bull market would come to an abrupt end.
A quick spike in interest rates at the time gave a sense that times were indeed changing. Yet investors end up shrugging off that noise: The SP 500 rose an impressive 22% between July 1 of last year and June 30 of this year. Toss in dividends and investors garnered a 25% total return -- roughly the amount investors should expect to garner over a three year period in normal times.
But these are not normal times. The stunning 191% gain for the SP 500 since bottoming out in March 2009 is remarkable in light of the fact that the subsequent economic rebound after the Great Recession has been quite tepid. Low interest rates, a huge amount of global liquidity and very high corporate profit margins all get credit for the bull market that has exceeded the wildest expectations of even the most aggressive market strategists.
At this point, it might seem the wisest path to sit back and enjoy the ride, waiting for another 20% gain over the next 12 months.
Yet before you grow too complacent, you need to take a closer look at factors driving the market higher and assess what kind of backdrop we should expect in the six months ahead. Here are key events and factors you should be tracking.
At this point, there are really only two points of economic interest: unemployment and inflation.
The former is falling and the latter may be rising. We now know that the U.S. economy created at least 200,000 jobs for the fifth straight month. That's the first time that has happened in more than a decade. The next payroll report comes on Aug. 8, and if that report also highlights a gain of at least 200,000 jobs, then it's hard to see how the Fed will stick by its "no rate hikes in the near future" policy.
Inflation is the other item you should be tracking, especially the core Consumer Price Index. The next reading will come July 22. Inflation levels are still fairly low in the context of long-term price pressures. But the core consumer inflation rate has ticked up recently, and even if it's creeping up slowly, the trend is disconcerting for the Fed, which must maintain its mandate for price stability.
Companies have been delivering knockout profit margins over the past few years -- not because they have great pricing power, but because they have maintained a very tight lid on staffing levels, compensation and, equally important, capital spending. The solid margins have fueled a frenzy for dividend boosts and share buybacks at an unprecedented pace, which has in turn helped fuel the bull market.
But if the economy strengthens in the second half of the year, then capital spending is also likely to firm up, right at time when employers also need to consider raises for employees that may be tempted to start looking for another job. That backdrop may portend a pullback in margins, which in turn, will make year-over-year profit comparisons more difficult in coming quarters.
But that scenario is not necessarily a negative for stocks. Investors may be willing to tolerate a lull in profit growth if they believe that stepped-up investments by companies now (in their labor force and capital equipment) create better positioning for a faster-growing economy in 2015 and 2016. There is a precedent: A large wave of investments in headcount and corporate infrastructure led to a 7% drop in aggregated SP 500 profits in 1998. Yet that index rose 27% that year.
To be sure, recent earnings seasons have turned out to be snoozers, and many expect the coming wave of second-quarter results to be undramatic. Still, you need to keep a close eye on quarterly results and outlooks (even if the beach beckons). The most important reports -- in terms of signals for the U.S. economy -- will come in the first two weeks of earnings season. By July 18, when GE (NYSE: GE) weighs in, we'll already have a clear read on the issues of margins, capital spending -- and the market's reaction to them.
Later this summer, parents will be trotting to the malls to buy all the clothes and supplies needed for the coming school year.
It could be a very robust period, mostly because the past few back-to-school seasons have been so dismal. This continues to be a great time to start researching any retailers that have had a tough go in recent years. A firming economy in the second half of 2014 could bring a flood of institutional money (such as mutual funds and hedge funds) pouring into value-laden retail stocks.
We didn't think it would be possible for the gridlock in Congress to deepen, but it has.
We're at the point where funds to pave highways are now so scarce that projects are getting canceled, simply because Congress can't decide on a highway bill. It's unclear if the foot-dragging in Washington will lead to a wave of "throw the bums out" sentiment in November, or if the next Congress will be even more partisan and even more deeply deadlocked. The prospect of a frozen government for the final two years of the Obama administration has led to rising concerns from the U.S. Chamber of Commerce that out nation's competitiveness will start to erode.
How would the markets react to deeper gridlock? The SP 500 fell more than 100 points in the period between the four weeks prior to the 2012 elections and one week after.
Risks to Consider: A firming economy might be so large a tailwind that it overpowers all the potential headwinds of lower profits and rising interest rates.
Action to Take -- Investing has become very easy. You buy a stock or a fund, and it rises in value. But for anyone who has been through a number of market cycles, it's clear that this uninterrupted winning streak is pretty unusual. As the market move ever higher, price-to-earnings (P/E) ratios start to move to hard-to-tolerate levels. The inverse of that ratio (known as the earnings yield) has moved ever lower as a result, though it remains higher than the yield offered by fixed income investments such as bonds and CDs.
The key question for the next six months: Will investors start to conclude that the shrinking gap between the corporate earnings yield and soon-to-rise interest rates is no longer worth the risk? We'll have an answer to that question in coming months.
In the past year, Street Authority recommendations on individual stocks have gained +72%, +26% and +60% all in less than six months... and recently, their trades could have made you +26% in 42 days and +42% in less than one month. Click here to get the free trading advisory -- Trade of the Week.
