Third Quarter 2014 Forecast and Opinion

As we reach a historically volatile period for stocks (mid-September through mid October), investors should keep in mind that we are about to enter a more favorable season. Over the past 25 years, the VIX, or volatility index, tends to peak in mid-October, and then eases off into the year end. The stock market also tends to perform better than average in a midterm election year of the Presidential cycle. While many feel that the bull market is ready for a pause, keep in mind that cash levels as a percent of GDP are higher than they been in many years, even after a 5 year rally. Company profit margins are still high, with no wage pressure impacting them negatively yet. The economy continues to improve, as factory orders, manufacturing and services all expanded robustly in the third quarter. Business and consumer confidence remains elevated, the housing market, particularly for new homes, remains well oriented, and inflation remains benign.

What is not as healthy is the U.S. labor participation rate, which remains very anemic at 62.8% of the population (it was as high as 67.3% back in early 2000). The “underemployment” rate, now at 12%, is still well above the peak of the last pre-crisis recession of 2000-2003, when it rose to around 10%. These two facts, combined with a lack of evidence of any wage inflation, argue for small and very measured rate increases next year by the Federal Reserve as opposed to any more aggressive moves.

While there are no red flags on the economic front, the stock market may soon approach a ”rich” valuation level.
The P/E ratio of the S&P500, as measured on a 12 month forward basis, currently stands at 15.3. Over the last 10 years, that ratio has varied between 11 and 16. One might argue that there will be limited “multiple expansion” (higher P/E ratios) going forward, as profit margins in the U.S. are at an all time high and profits will be pressured if labor markets become tighter. Company stock buybacks are slowing down now as well, in part because the cost of borrowing for riskier companies is increasing. Since most firms have cut costs to the bone, earnings growth will be required henceforth to make the market climb. Still, the liquidity generated by quantitative easing, combined with eventual flows out of bonds and into stocks, may give us further gains ahead. Considering that after inflation a ten year Treasury bond yield is barely positive, stocks still look attractive.

The trade-weighted dollar index has appreciated by some 7% since the beginning of the year. Against the Euro and the Yen, it has appreciated by 9.2% and 4.5% respectively. This is a negative for U.S. exporters whose costs are based in dollars, like defense and aerospace manufacturers, and can provide a headwind for large cap multinational companies.

The price of oil has been falling, which provides a tailwind for the U.S. economy. This is due to both supply and demand forces at work. While China and Europe have slowed their demand, OPEC production has been rising. It should be remembered that in order to cover its fiscal budget, Iran needs a barrel of oil to trade above $130. Saudi Arabia is clearly using its financial position to bring Iran to the negotiating table over the ISIS conflict, as Iran is shut off from the world’s capital markets and cannot borrow. However, even Saudi Arabia needs oil to trade above $89 per barrel for its own budgetary reasons. Because of this, OPEC may decide to cut its output targets at its November meeting in order to drive prices higher. A cold winter in the United States could certainly bring prices substantially higher. There is certainly no geopolitical risk built into $91 oil, or as demonstrated by the small spread between European oil (Brent).and US oil (WTI crude).

For the first three quarters of 2014, the Dow was up 2.8%, the S&P 500 was up 6.7%; and the Nasdaq was up 7.58%.


Grant Rogers

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