In mid-October the S&P 500 Index was at 1428.50 and I suggested (despite all the pessimism at that time) that if rates and inflation remained steady we could see the index move 20% higher. To be precise I reasoned:
For what it’s worth, my experience teaches me that even “if” 3% is where long term Treasuries should be, investor expectations tend to be erratic. Since it is widely known that governments have worked furiously to depress interest rates, what happens when they pop a bit? Don’t be surprised then if the discount rate investors implicitly use to value the stock market also shoots up to 7% or higher over the next month or two. A correction (downside) will hurt stocks even if it is a short-lived one. Also, don’t forget window dressing.
The good news is that earnings will continue to improve, yet modest (if any) growth in China and Europe and stubborn U.S. unemployment should help keep even the 10-year Treasuries at no more than 3% (look out bondholders). Early in the spring, after a brief panic we could all get comfortable with a 5% discount rate for the stock market again.
For what it’s worth, I was bang on (don’t be impressed, it’s a curse). The market corrected during the fourth quarter on schedule and when it was clear there was no inflation (or interest rate) threat it did recover.
At 1515.60 (up 6.1%) we’re getting closer to full value holding interest rates and inflation constant. Admittedly since then the index has risen (and earnings have improved) so if I had to re-examine the upside from today for the S&P 500 ceteris paribus the potential would be now more like 10%.
Of course, nothing ever remains constant and we’re already seeing signs of a potential bogeyman…..or two.
1) Interest Rates: There’s already plenty of talk about the prospect of rising interest rates hurting the bond market. I discussed this in my previous commentary, but it doesn’t hurt to remind oneself that a bump in interest rates will also create pressure (even if temporary) on the stock markets.
2) Inflation Expectations: Benign inflation data has thus far kept expectations modest, but rampant growth in the money supply will likely have repercussions. According to the University of Michigan consumer confidence survey, inflation expectations for the short-term (1 year out) haven’t changed and remain at 3.3 percent, but expectations for inflation 5 years out ticked up to 3.0 percent from 2.9 percent. The P/E on the S&P 500 Index has climbed to an estimated 18X. Inflation expectations (although starting to increase) five years out seem extremely low especially when we consider monetary policy of late. Higher inflation will lower the P/E.
It will be a battle between earnings growth (+) versus interest rates (-) and actual/expected inflation (-). Fund flows may give stock markets the legs needed to trend another 10% higher or more. It is now accepted (whether true or not) that bonds will lose some money while the outlook for stocks is considered better (since they have been and still might make money).
It’s no wonder that several members of the Federal Open Markets Committee are worried about continued monetary stimulus. If it weren’t for negative news coming from Europe and China I suspect the FED’s minutes would’ve caused more damage than we saw. Expect more money to flow into equities in the short-term, but start holding onto a bit more cash. The growing money supply will cause inflationary pressure. When the market corrects because the FED backs off the accelerator, then it will be time again to dive right in.
|Percent change at seasonally adjusted annual rate||M1||M2|
|3 Months from Oct 2012 TO Jan 2013||6.7||7.7|
|6 Months from Jul 2012 TO Jan 2013||12.9||8.6|
|12 Months from Jan 2012 TO Jan 2013||11.8||7.5|