They will rise this year, but not dramatically. Early in 2013, when the Street was cautious, we expected “valuation levitation,” which happened. Late last year we warned rising complacency would lead to higher volatility, but we stayed positive as investors “reach for yield.” Volatility has indeed soared as momentum stocks collapsed. What next? Profits will rise 8-9% this year and so will stock prices, to around 2000 on the S&P 500. Most of the return will likely come in the fourth quarter, after Republicans do well in the November elections.
Profits Will Be OK, Not Great
I see no reason for either the U.S. or global economy to accelerate meaningfully this year. Economists continue to underestimate the negative impact of Obamacare on hiring (which, by the way, has not improved over the past two years). A friend of mine saw his monthly health insurance costs rise from $750 to $1,750, with higher deductibles; he is not unusual. And keep in mind the employer mandate has yet to be implemented. The NFIB small business optimism index remains in recession territory. Obama continues to resist pro-growth measurers such as the Keystone Pipeline and corporate tax reform. His push for a big hike in the minimum wage discourages hiring. But capital spending may pick up modestly; for example, truck orders look fairly strong.
Globally, the main positive is that Europe, a key market for U.S. multinationals, is growing rather than shrinking. But let’s not exaggerate the improvement; France and Italy are stagnant, and the banking system still needs to de-lever. (Europe lags the U.S. by five years in this department.) The key emerging market, China, is slowing and many others have political / economic problems that retard growth (e.g., India, Brazil, Venezuela, Egypt, Turkey, Russia, Thailand).
Against this tepid economic backdrop, with profit margins are at all-time highs, a major positive profit surprise is improbable. We look for SPX EPS of $119-$120 in S&P 500, which is roughly the top-down consensus.
The Message from the “Early Reporters:” Fairly Positive
They were mixed but not bad. We saw good or in-line results from Paychex, Fastenal, Cintas, Monsanto, Micron, Kroger, General Mills and ConAgra. JB Hunt, a major trucking firm, posted solid 9% revenue growth. Poor results from Bed Bath & Beyond and Family Dollar partly reflect bad weather and vulnerable business models.
More worrisome were poor results in the two most important “swing factors” for profits—big energy and big banks. Chevron preannounced soft results; big oil is spending oodles of money but not finding much oil. JP Morgan, particularly its FICC division, is being hit by tougher regulation; Wall Street analysts have done a poor job assessing just how much Dodd Frank will weigh on profits as compliance costs rise, trading revenue slows, and balance sheet leverage declines. I will be interested to see Goldman’s Q1 results. (Wells Fargo’s Q1 was better than JPM, with 4% loan growth. But the beat was low-quality.)
Thirst for Yield Supports Equity Valuations
Janet Yellen is a full-feathered dove. Even if rates do start to rise late next year money market funds’ average return in 2016 will probably be less than 1%. Meanwhile, bonds are expensive and risky. So large-cap stocks are attractive for yield-oriented investors. SPX DPS growth has average 15.5% over the past three years; with the payout ratio still low at 32%, dividends will probably grow 15-17% this year. (The 2013 comparison is easy because some firms accelerated dividend payments to Q4 2012, before tax rates rose.) The S&P 500’s current yield on 2014 DPS is 2.2%, but it is easy to assemble a portfolio yielding 3-4%. Investors’ thirst for yield should keep the trailing PE on pro forma EPS about where it was at the end of last year, 16.8x, implying a year-end price of 2000 (16.8* $119 = 1999).
History Strongly Suggests Most of the 2014 Return May Come in Q4
Stocks should act better over the next month as attention turns from downbeat “sentiment” about high-fliers to decent “fundamentals” revealed in Q1 profit reports. Even if Q1 earnings are not great, managements will highlight improving demand in March and April (as Fastenal, an industrial bellwether, did). That said it may take a while for investors to digest the demise of momentum stocks. Before long we will be in the August doldrums, followed by the pre-election jitters in September and October. So stocks may not do much in Q2 and Q3 and then perform well in Q4 following a strong Republican showing in the election. There is a very pronounced tendency for stocks to be strong in the fourth quarter of mid-term election years. Consider:
- Looking, first, at all 69 years since 1945, stocks tend to be strong in Q4. The average pattern of S&P 500 price return by quarter is: Q1 +2.2% / Q2 +2.0% / Q3 +0.4% / Q4 +3.9%. If we look at median price returns, Q4 strength is even more pronounced: Q1 +2.2% / Q2 +2.1% / Q3 +2.5% / Q4 +4.9%.
- Now let’s look at 17 mid-term election years since 1945: The average return in Q4 is 7.7% and the median is 7.9%. That is far above the typical Q4 return, and nearly four times the typical quarterly return in the first, second and third quarters of all years since 1945.
Obviously, past may not be prologue. Unexpected events may intrude. But in current circumstances the historical norm seems very relevant.
Copyright Thomas Doerflinger 2014. All Rights Reserved.