The Independent Market Observer

1/29/13 – Markets Are Strong—Will It Continue?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jan 29, 2013 10:27:31 AM

and tagged Market Updates

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The S&P 500 Index recently closed above 1,500 and is making a bid to go up from there. Fund flows are starting to move away from bonds and back toward equities—for the past month, anyway. There is speculation that the “Great Rotation” away from bonds and back to equities is underway. Is it so? And if it is, what will that mean?

Quite possibly it is true, and if so it could mean a lot. Sentiment seems to have shifted substantially with respect to the stock market, with investor surveys at historically very high levels. When narratives shift, the effects can be big and lasting. But sentiment can only go so far, and so it pays to look at the underlying fundamentals as well.

For the equity market to continue to rise, one of two things must happen. Either earnings per share have to increase or investors have to be willing to pay more for a given stream of earnings—a figure known as the price-to-earnings multiple. Where are we now on these?

According to the Commonwealth research group, just under two-thirds of companies have beaten earnings estimates so far for this quarter, which is in line with 2012 and helps positive sentiment. Although companies have done well thus far, we do expect downward revisions for earnings in the second half, which won’t help positive sentiment. This suggests that market growth will get less support from earnings for the year as a whole than from multiple expansion.

In 2012, multiple expansion—or investors paying more for a given stream of earnings—was a primary driver for the strong stock market performance. It seems quite possible that 2013 could see the same result, even if earnings do roll over in the second half.

Technically, as the market advances and breaks significant levels, such as 1,500 for the S&P 500, investors typically become more willing to invest, which is a trend that we are seeing now. If fund flows continue to move away from fixed income and into stocks, the growth in demand will make it quite possible for the market to continue to appreciate strongly.

The other side of the argument, though, is that market appreciation is based on current conditions continuing. We saw the first signs today that they might not—a drop in the consumer confidence number that economists attribute to the recent tax increases, which cut into paychecks. This tax increase will certainly reduce consumer demand and serve as a headwind for the economy as a whole. Moreover, the pending spending cuts—of uncertain magnitude—will be an economic and growth headwind. Both combined could hit the economy, and corporate earnings, even harder. Worse, by negatively impacting growth expectations, they could induce investors to be willing to pay less for a stream of earnings, leading to multiple contraction.

At this point, however, the odds seem to be that the market will continue to rally, at least for a while. The narrative seems to have shifted that way, and sentiment remains positive. Until and unless the economy gets hit harder by the tax increases and spending cuts than now seems to be the case, companies seem well positioned to keep meeting and beating expectations. Long may it continue.

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