The SPX closed up 5% for the quarter while September gained 3%. Companies in the index are forecast to report earnings up 4.6% year over year. Revenues are expected to be weaker than earnings. The index now trades at 15.6 times 2013 expected estimates of $108. Nearly 80% of the 18% stock market gain in 2013 has been due to rising P/E's rather than rising earnings. This is unusual.
The rosy $114 estimate for next year is based on a belief that capital spending will pick up and the global economy has bottomed. Stock prices normally rise as we get higher earnings particularly when combined with below normal interest rates.
The 10 year Treasury note traded around 6% for decades prior to the financial crisis. In September it closed with a 2.64% yield up significantly from 1.66% in May this year. Bears believe higher rates will drive stocks lower along with bonds but it has not yet happened. However the spell of rising bond prices started in 1981 appears to be broken. We are a long way away from normalized rates which should keep P/E ratios at the high end of historic ranges.
The Federal Reserve failed to reduce its $85 billion dollar/month bond buying program recently which surprised the markets. The Chairman had spoken of tapering in May driving up yields, now investors are confused. It seems the Fed’s talk of tapering drove rates higher then they had anticipated. Given the current norm of +2% GDP levels the Fed needs to keep it's QE policy going.
Slow growth in this year's first half was due to higher income taxes plus uncertainty over Obamacare's costs to small business. This one two punch kept employment lower than what it might have been. Both individuals and CEO's are still hoarding cash and refinancing debt. Big business waits for corporate tax rules to change before investing more in the U.S. The Fed policy helps financial assets more than the economy or employment.
Small-Cap Growth funds have outperformed Big Cap Growth and Value funds. Growth stocks outperform slower stable and cyclical stocks in weak economic periods. Dividend focused investing has taken a back seat on this year's investment train.
Euro zone investor confidence turned positive for the first time in two years. The Europe 350 Index rose 5% this past month. Emerging markets rose 6.5% in September boosting 3Q gains to 5.1% after a rocky start in the first half.
Now we see Congressional budget negotiations have reached an impasse resulting in a partial government shutdown. This drama will likely continue until the October 17th when the current debt ceiling is reached. After this point, revenues received by the government must equal those spent by government. What a novel concept! Interest on the debt can and will be prioritized for payment if necessary.
If Congress and the Administration can ever manage to seriously address issues like Social Security, Medicare and Corporate tax reform we may experience a significant rise in market prices. For now share buybacks and dividend increases by rich corporations will continue to support markets. It appears that an unexpected recession or an exogenous shock to the financial system could derail this rosy scenario. We view this as unlikely any time soon.
European and Emerging markets are cheaper than the U.S. at current levels but are perceived to be more risky. As their economies do better they represent an interesting investment opportunity.
Lower quality bonds of short duration have outperformed higher quality, longer maturity bonds. This should continue to play out until the economy weakens materially.
Investor’s Business Daily pointed out that in the last 17 U.S. Government shutdowns the S& P 500 typically falls in the first week but ends higher a month later. October also marks the end of the DOW and S&P “Worst Six Month" period for share prices.
Doug Coppola
October 4, 2013
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