Originally posted at Briefing.com
2015 is right around the corner. My, how time and the stock market have flown. The S&P 500 is up 12% year-to-date, excluding dividends. The fundamental setup for 2015 doesn't look all that bad at this point either. In fact, things look better on that front in a number of respects than they did at the end of 2013.
Exit Strategy
Entering 2014, the yield on the 10-yr Treasury note was 3.04%, the PCE Price Index was up 1.2%, oil prices were $98.42 per barrel, the number of workers on nonfarm payrolls was 137.4 million, the target range for the federal funds rate was 0.00 to 0.25 percent, the S&P 500 was trading at 15.4x forward twelve month earnings, and the earnings yield was 349 basis points above the 10-yr yield.
Exiting 2014, the yield on the 10-yr Treasury note is 2.17%, the PCE Price Index is up 1.4% (and headed lower with the drop in oil prices), oil prices are $56.00 per barrel, the number of workers on nonfarm payrolls is 140.0 million, the target range for the federal funds rate is still 0.00 to 0.25 percent, the S&P 500 is trading at 15.9x forward twelve month earnings, and the earnings yield is 393 basis points above the 10-yr yield.
The market multiple isn't cheap. It's a slight premium to the historical average, yet long-term interest rates and inflation are also both well below historical averages.
Accordingly, there is some fundamental ground to stand on when making the case that the stock market should have another positive year in 2015.
That doesn't mean, however, that the ground won't shake, rattle, and roll along the way.
Risks Can Cut Both Ways
If you weren't aware already, emotions run high in this stock market. That is because policy rates have remained at the zero bound for six years, producing some trading speculation and no shortage of opinions about the implications of that policy and the potential changes in that policy.
We know courtesy of Fed Chair Yellen that it is unlikely the FOMC will begin to normalize policy for at least the next couple of meetings. That's based on what the Fed knows about the economy today and where it thinks it is headed, yet the timing of any rate hike(s) will be driven by incoming data and what it suggests about the Fed's progress toward meeting its dual mandate of maximum employment and price stability.
It can be gleaned from the fed funds futures market that the first hike is expected in the second half of 2015, with a higher probability (68%) of it happening at the September meeting than the July meeting (53%).
There is a risk factor then involved with a fed funds rate hike that comes sooner than expected. Given the market's sensitivity to the Fed's dovish leanings, an earlier-than-expected hike would be categorized as a downside risk factor -- and one that could be compounded if incoming data create a sense the FOMC is behind the rate hike curve.
The latter would rattle the market, which could roll over sharply as it questions market valuations that are based on assumptions that record-high profit margins will be maintained with the help of low interest rates.
That isn't a forecast, but it is a risk factor investors should be acutely aware of entering 2015.
Geopolitical turmoil, ongoing strength in the dollar that crimps sales and earnings prospects for U.S. multinationals, currency wars/crises, systemic dislocations, and the onset of deflation in the eurozone and elsewhere are additional factors carrying downside risk for the U.S. stock market outlook.
To be fair, not all risks are imbued with negative connotations for the outlook. For instance, a rotation out of Treasuries and into stocks that is precipitated by a strengthening U.S. economy and confidence in the Fed's policy management is considered an upside risk that could help stocks rock and roll.
Tax reform that produces lower corporate tax rates could be another element that factors favorably for the U.S. stock market outlook.
An Abnormality
Notwithstanding the uplifting fundamental backdrop, the crash in crude oil prices and steep declines in other commodities like copper and cotton just isn't sitting right with us.
Granted we agree that lower energy prices are a net positive for the consumer and the economy, but there is something abnormal about a major industrial commodity like oil dropping 50% over the course of six months when (a) the market knew on the way to its high price in June that there was excess supply and (b) it runs counter to all of the talk about global economic prospects improving on the back of a strengthening U.S. economy.
Lower oil prices will ultimately invite more demand that should shore up prices, yet we can't help but think that there is some latent financial risk, and maybe even some economic risk, in that price rout.
It leaves us with an uneasy feeling entering 2015 that we'd like to see dissipate sooner rather than later.
Better, but Not Great
With respect to our economic outlook, we are expecting 2015 real GDP growth on the order of 2.8% -- better than what it has been, yet still not above the 3.0% growth rate associated with hitting escape velocity.
The inflation rate, meanwhile, isn't expected to get to the Fed's longer-run target of 2.0%. The Fed for its part doesn't think it will get there either as its central tendency projection for the PCE Price Index in 2015 is 1.0% to 1.6% (core PCE is 1.5% to 1.8%) with lower oil prices expected to tamp down broader inflation pressure.
The risk to the inflation view lies in faster wage growth, which has been flat for the last five years. If wage growth accelerates, the Fed may be forced to re-think the timing and pace at which it raises the fed funds rate.
A scenario, though, in which the economy continues to grow below potential and inflation continues to run at or below the Fed's projections should foster a patient mindset at the Fed when it comes to raising the fed funds rate.
What It All Means
With the fundamental underpinnings noted above, there is a reasonable basis to think the S&P 500 will have another positive year in 2015, albeit with some increased volatility along the way as market participants ruminate about the direction of Fed policy and central bank policies in general.
Given festering concerns about economic slowdowns abroad, a stronger dollar weighing on earnings prospects for U.S. multinationals, and the effects of potentially higher policy rates in the U.S., multiple expansion should be hard to achieve.
Our expectation is that market gains will track closer to EPS growth, which is currently projected at 8.8%, according to S&P Capital IQ.
With our base view being that the U.S. economy should continue to run along a recovery path and that the FOMC will raise rates in the latter half of the year, we'd expect to see relative strength in the cyclical sectors, the continued outperformance of large-cap stocks versus small-cap stocks, and a growing disaffection for highly-leveraged companies and companies financially engineering EPS growth.
Per usual, there needs to be a healthy appreciation for risk management. The crash in oil prices is a sobering reminder that sentiment can shift in a hurry when leverage is in play. With the potential for increased volatility, maintaining exposure to the countercyclical sectors would be prudent (That certainly helped matters in 2014. Despite all of the talk about the relative strength of the U.S. recovery, the countercyclical health care and utilities sectors have been the best-performing sectors, up 27% and 23%, respectively, year-to-date).
Our view is not static. Things happen when it comes to the future and the inherent limitation to predict it with certainty.
What we know today sets up well from a fundamental perspective for the stock market outlook:
- Interest rates are low
- Inflation is low
- Earnings are growing
- Nonfarm payrolls are increasing
- The fed funds rate is still at the zero bound; and
- Stocks remain a better long-term alternative than bonds
The Big Picture column, which I update weekly, will provide economic and investment perspective along the way that sheds light on our market tune...but I promise I won't sing.
Here's to a happy, healthy, and prosperous 2015!
