When the Federal Reserve first suggested a gradual tightening
of its monetary policy in May 2013, investors began to wonder if
the long-running bull market would come to an abrupt end.
A quick spike in interest rates at the time gave a sense that
times were indeed changing. Yet investors end up shrugging off
that noise: The S&P 500 rose an impressive 22% between July 1
of last year and June 30 of this year. Toss in dividends and
investors garnered a 25% total return -- roughly the amount
investors should expect to garner over a three year period in
But these are not normal times. The stunning 191% gain for the
S&P 500 since bottoming out in March 2009 is remarkable in
light of the fact that the subsequent economic rebound after the
Great Recession has been quite tepid. Low interest rates, a huge
amount of global liquidity and very high corporate profit margins
all get credit for the bull market that has exceeded the wildest
expectations of even the most aggressive market strategists.
At this point, it might seem the wisest path to sit back and
enjoy the ride, waiting for another 20% gain over the next 12
Yet before you grow too complacent, you need to take a closer
look at factors driving the market higher and assess what kind of
backdrop we should expect in the six months ahead. Here are key
events and factors you should be tracking.
At this point, there are really only two points of
economic interest: unemployment and inflation.
The former is falling and the latter may be rising (
as I noted a few weeks ago
). We now know that the U.S. economy created at least
200,000 jobs for the fifth straight month. That's the
first time that has happened in more than a decade. The
next payroll report comes on Aug. 8, and if that report
also highlights a gain of at least 200,000 jobs, then
it's hard to see how the Fed will stick by its "no rate
hikes in the near future" policy.
Inflation is the other item you should be tracking,
especially the core Consumer Price Index. The next
reading will come July 22. Inflation levels are still
fairly low in the context of long-term price pressures.
But the core consumer inflation rate has ticked up
recently, and even if it's creeping up slowly, the trend
is disconcerting for the Fed, which must maintain its
mandate for price stability.
Margins vs. Investment
Companies have been delivering knockout profit margins
over the past few years -- not because they have great
pricing power, but because they have maintained a very
tight lid on staffing levels, compensation and, equally
important, capital spending. The solid margins have
fueled a frenzy for dividend boosts and share buybacks at
an unprecedented pace, which has in turn helped fuel the
But if the economy strengthens in the second half of
the year, then capital spending is also likely to firm
up, right at time when employers also need to consider
raises for employees that may be tempted to start looking
for another job. That backdrop may portend a pullback in
margins, which in turn, will make year-over-year profit
comparisons more difficult in coming quarters.
But that scenario is not necessarily a negative for
stocks. Investors may be willing to tolerate a lull in
profit growth if they believe that stepped-up investments
by companies now (in their labor force and capital
equipment) create better positioning for a faster-growing
economy in 2015 and 2016. There is a precedent: A large
wave of investments in headcount and corporate
infrastructure led to a 7% drop in aggregated S&P 500
profits in 1998. Yet that index rose 27% that year.
To be sure, recent earnings seasons have turned out to
be snoozers, and many expect the coming wave of
second-quarter results to be undramatic. Still, you need
to keep a close eye on quarterly results and outlooks
(even if the beach beckons). The most important reports
-- in terms of signals for the U.S. economy -- will come
in the first two weeks of earnings season. By July 18,
weighs in, we'll already have a clear read on the issues
of margins, capital spending -- and the market's reaction
Back to School
Later this summer, parents will be trotting to the
malls to buy all the clothes and supplies needed for the
coming school year.
It could be a very robust period, mostly because the
past few back-to-school seasons have been so dismal. This
continues to be a great time to start researching any
retailers that have had a tough go in recent years. A
firming economy in the second half of 2014 could bring a
flood of institutional money (such as mutual funds and
hedge funds) pouring into value-laden retail stocks.
We didn't think it would be possible for the gridlock
in Congress to deepen, but it has.
We're at the point where funds to pave highways are
now so scarce that projects are getting canceled, simply
because Congress can't decide on a highway bill. It's
unclear if the foot-dragging in Washington will lead to a
wave of "throw the bums out" sentiment in November, or if
the next Congress will be even more partisan and even
more deeply deadlocked. The prospect of a frozen
government for the final two years of the Obama
administration has led to rising concerns from the U.S.
Chamber of Commerce that out nation's competitiveness
will start to erode.
How would the markets react to deeper gridlock? The
S&P 500 fell more than 100 points in the period
between the four weeks prior to the 2012 elections and
one week after.
Risks to Consider:
A firming economy might be so large a tailwind that it
overpowers all the potential headwinds of lower profits and
rising interest rates.
Action to Take -->
Investing has become very easy. You buy a stock or a fund, and it
rises in value. But for anyone who has been through a number of
market cycles, it's clear that this uninterrupted winning streak
is pretty unusual. As the market move ever higher,
price-to-earnings (P/E) ratios start to move to hard-to-tolerate
levels. The inverse of that ratio (known as the earnings yield)
has moved ever lower as a result, though it remains higher than
the yield offered by fixed income investments such as bonds and
The key question for the next six months: Will investors start
to conclude that the shrinking gap between the corporate earnings
yield and soon-to-rise interest rates is no longer worth the
risk? We'll have an answer to that question in coming months.