What Lies Ahead for Stocks?

The stock market has been on a tear this week, making new highs while defying negative trending economic news and continued impasse in Washington on vital fiscal policies. The
S&P 500 rose 0.4% yesterday to close at a record 1,593.37. It reversed this morning on news that retail sales for March came in well below expectations and that the weakness was broad based.

The retail sales report surprised economists with a decline of 0.4% following a strong 1.0%in February. Analysts were looking for a 0.3% gain. The drop is due to weak employment and the termination of the two-year payroll tax holiday which boosted that tax from 4.2% back to its 2010 level of 6.2%. Weakness centered on discretionary items as consumers are paring back on non-essentials. The tax reversion represents $83 a month for a person earning $50,000 a year.

Retail sales are vital because consumers represent 70% of the nation’s economy. Consumer surveys can sometimes provide insight into how they will behave in the coming months, but not always. Sentiment as measured by the Reuter’s/University of Michigan’s consumer sentiment index bounced strongly for the second half of March from 71.8 to 78.6. According to Econoday, the final reading implies a mid-80s pace for the final two weeks of the month, the very strongest pace of the whole recovery.

Unfortunately, a separate Bloomberg Consumer Comfort Index did not confirm the Reuters index as it remained flat in negative territory. A couple of bright notes showed that responders were less intensely negative on their views of the economy and high-income earners were more upbeat.

While there seems to be some movement toward bipartisanship in Washington, it is in areas that have little or nothing to do with our economy, at least in the short run. Much is being said about senators crossing the isle on gun control and immigration, but the release of the President’s budget has mostly been scorned by Republicans who want to see real cuts in entitlements before they will offer any more compromise on tax cuts.

If economic news, consumer news, and Washington news isn’t driving the stock market, what is? One possible answer is that the Fed seems set on continuing its money-printing and Quantitative Easing policies well through the year. Minutes released this week from the last meeting show that Fed members believed that while economic data (then) was more positive than had been expected, fiscal policy (sequestration and gridlock) had become more restrictive, leaving their outlook for the economy little changed since January.

As for the Fed’s continued stimulus, “most participants saw asset purchases as having a meaningful effect in easing financial conditions and so supporting economic growth. Some expressed the view that these effects had likely been stronger during the Federal Reserve’s initial large-scale asset purchases because that program also helped support market functioning during the financial crisis. Other participants, however, saw little evidence that the efficacy of asset purchases had declined over time, and a couple of these suggested that the effectiveness of purchases might even have increased more recently, as the easing of credit constraints allowed more borrowers to take advantage of lower interest rates.”

The Fed’s efforts to stimulate the economy artificially boosts stock prices, but they boost them nonetheless. By making bonds more unattractive than ever, they force more savers into risky assets like stocks. The current dividend yield on US stocks is 2%. Compared to zero money market and near-zero CD and bond rates a 2% yield with the possibility of appreciation (11% year-to-date and more than double since March 2009) sounds attractive to more people as they set aside their fears to buy in. Should they?

In economic terms the Fed hopes to drive stock prices up and thereby encourage companies to invest and hire. Higher stock prices motivate consumers to spend more. The subsequent increased demand encourages companies to invest and hire more. The Fed hopes its artificial stimulus measures will prime the economic forces of supply and demand that drive the real economy, and do so before all that money sloshing around causes more harm than good.

Fundamentally, stocks’ rise and fall are based on their earnings – earnings of the individual companies that comprise the individual stocks. A huge driver of recent earnings growth has been the country’s growing fuel independence. According to the Energy Information Administration, the US produced 84% of its own energy in 2012, the most since 1991. The self-reliance measure rose to 88% in December, the highest since February 1987.

But analysts forecast that earnings of S&P 500 companies fell last quarter for the first time since 2009, projecting a 1.4% decrease from the first quarter of 2012, according to data compiled by Bloomberg. Profit growth is projected to return later in the year, with full-year earnings forecast to increase 7.3%. Will they?

If you use economic trends and earnings projections to direct your investments, you would do well to consider that this current bull market is approaching its end, statistically speaking. From a valuation standpoint things don’t look so good either. The Shiller P/E suggests the market’s return from here is only 2.3%, which is essentially the dividend yield.

Of course these measures could lead to wrong conclusions. The growing chorus of long-time bearish brokerage prognosticators recently turned bulls (after 100% market increase), could be right as they suggest that much higher market returns await.

As you know, we don’t gamble our clients’ current or future lifestyles on market calls. In fact we obsessively and continually warn any who will listen against it. When markets rise for years they breed a false sense of correctness in the market-player’s approach and he begins to feel invincible. However, for every period of market’s rise, there invariably comes a significant period of downturn that can damage wealth when cash flows are considered.

Our disciplined approach relies on the planning of future cash flows and enables us to measure the market risk in each one of our clients’ plans with robust clarity. Rather than saying, this may be a good time to lighten your equity exposure because we ‘feel’ markets are overextended we say, where indicated by each plan, ‘that because of excellent stock market returns of late your plan is now overfunded. You have already told us in your plan what your priorities are when you become ‘overfunded;’ you might reduce savings and spend more, increase a future goal, or act on one sooner, OR you might reduce your exposure to stocks when the market provides ‘opportunities’ such as we now experience with many of our clients.

We don’t know where the stock market is headed (but you knew that already). We do know that investing money marked for serious purposes on guesses (however ‘well-informed’) about an uncertain future is unwise and most often leads to diminished wealth.

The secret, we believe, to investing in the stock and the bond markets is to respect uncertainty and to continually measure how it impacts each one of our clients’ plans individually. By carefully and systematically doing so we identify opportunities and threats that are otherwise lost in the white noise created by the financial media and services industry.

Have a nice weekend.