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Have The S&P And Dow Seen Their Highs For The Year?

Via ConvergEx's Nick Colas,

Have the S&P 500 and Dow Jones Industrial Average seen their highs for the year?  At this point in 2014, it’s probably a coin toss.  There are several factors in favor of a further rally, to be sure.  Corporate profits are still robust, revenue expectations are modest, and long term interest rates remain equity-friendly.  On the flip side of the U.S. equity market coin: long term valuations are toppy, plenty of other markets (commodities, bonds) seem to signal an impending global recession, and a host of geopolitical concerns now seem to be hitting a full boil. Also, let’s not forget that the Russell 2000 peaked in, oh, March (1209) and July (1208) and is down 8.8% from that last high. By that measure, equities are already rolling over. It is true that markets climb a wall of worry. Until it falls on them.

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Sometime in my early teenage years, my parents decided it was time I learn the appropriate protocols for dating. Since I had no actual prospects, the whole discussion was uncomfortable and unnecessary.  Still, their faith in my eventual introduction to society was reassuring, so I let them talk. Their advice centered on the correct way to pay a restaurant bill. They assured me that this was very important.

I remember their counsel to this day, and it went like this:

  • At some point during the coffee service post-dinner, your date will excuse herself and leave the table.
  • This is your cue to ask the waiter for the check. You do this by signaling with a gesture that resembles the signing of a credit card slip.
  • You take care of the bill and hand the folder back to the waiter and shake their hand to thank them. 
  • Your date magically returns, never having had to see a crass exchange of money.

Yes, my parents were from a different time and place so this was all they knew.  Needless to say, I spent many years wondering why no one seemed to go along. The random times when a date did follow the guidelines never seemed to repeat itself, even when it was the same woman both times. I am sure somewhere – perhaps among minor European aristocracy – my parents’ advice is still relevant. But nowhere else.

I feel a similar confusion now, looking at charts of the S&P 500 and the Dow Jones Industrial Average.  The playbook I learned in the 1990s was “Don’t fight the Fed”.  When the U.S. central bank starts to raise interest rates, you ask for the check and move to the sidelines until things shake out. Until then, stocks are the place to be. But the price action of the last few days is causing flashbacks to my first dates as a young man. Which is to say confused and anxious that no one seems to know the script but me.

Have U.S. stocks peaked for the year, ahead of the Fed’s anticipated moves to raise interest rates in 2015?  The simple case for a “Yes” answer is that markets discount earnings and macro events roughly 6 months in the future. If the Fed is to raise rates in Q2 2015 – the current wisdom – then a selloff starting about now would be perfectly consistent. At the same time, U.S. stocks have been resilient for years. A “Chicken Little” bearish case hasn’t been especially prescient during that time.

The bullish case for U.S. stocks is both reassuringly and maddeningly straightforward. There’s no real magic to the argument; it essentially hopes that investor psychology stays pretty much in the same vein as the last 5 years.

The highlight reel is as follows:

Corporate earnings remain robust. The S&P 500 index companies reported earnings of $25/share last quarter, and $27/share on an operating basis. This quarter is slated to run closer to $27/share reported and $29/share operating. Yes, I know companies buy back a lot of stock and that helps the comps. But that’s a good thing if you are a shareholder. Even if earnings grow no further, the S&P 500 will earn $108/share over the next 4 quarters. And that is an all-time record in the midst of a subpar U.S. economic recovery and a tough picture in Europe. Pretty impressive, that.

 

On this basis, valuations aren’t horrible. Damning with faint praise, yes, but consider the numbers. At current prices, U.S. stocks are at 18x earnings. Given that 10 year Treasuries yield 2.5%, that’s about right. And if corporate America can continue to grow the earnings base (and after the last 5 years of excellent bottom line results why doubt that?), then stocks have further room to the upside.

 

Interest rates remain low, which not only helps stock valuations but consumer purchases of houses, cars, and other big-ticket items. Job growth isn’t great – hence the low rates – but it is good enough to create some (2-3% GDP) economic growth.

 

Revenue growth in corporate America has been anemic since 2010, but expectations are quite low for Q3 and Q4 2014. After years of seeing their companies miss top line growth targets, Wall Street analysts finally have some beatable revenue numbers in their models. For the companies of the Dow Jones Industrial Average, for example, these are just 2.3% and 1.6% for the next two quarters. Consider that population growth runs 1% and inflation is 2%, those modest hurdles indeed.

The bearish case on the same points looks like this:

Valuations are super-rich by historical standards. Just look at the Shiller P/E, a measure of current stock prices versus the average of the last 10 years of corporate earnings. The current reading sits at 26.1x, against a long run average of just 16.6x.  Black Tuesday of 1929 occurred at 30x, and the peak in the dot com era was close to 45. The post-war lows were in the early 1980s at less than 10x.  Any way you look at this measure, U.S. stocks are not cheap.  Not even a little bit.

 

If you just looked at commodity prices and bond yields, you’d be bracing for a global recession in 2015 accompanied by strong deflationary pressures.  Crude oil at $90 and 10-year Treasuries yielding 2.51% are no one’s idea of a “Green means go” signal to buy stocks.  When one market – stocks – signals the potential for further earnings growth and multiple others refute that optimism, it is time to grow cautious.

 

Geopolitical concerns seem to be taking a bite out of equity market confidence of late.  The list of above-the-fold news stories that have taken chunks out of this market include: Russia/Ukraine, ISIS/Iraq, Chinese economic slowdown, Hong Kong protests and (as of tonight’s aftermarket announcement) Ebola in the U.S.

The bottom line is that the positive and negative stories for U.S. stocks are quite evenly weighted.  Possibly as even as we’ve seen since the March 2009 lows. Yes, you could add more weight to one or the other sides of this scale, but overall the balance is pretty even.  If the last five years of stock market history has any weight, the bullish argument should continue to hold and we will see one more run to new highs in 2014. As for me, I think I will ask for the check.