Market Memo: It's a grind, and that's OK
We’re completing a quarter in which growth in the U.S. economy has been slower than in the first half, the Chinese economy has continued to decelerate and corporate earnings have been flattish. So why is the equity market up and setting new cycle highs? It’s up because it’s becoming increasingly convinced that Europe—and the euro—is not going to blow up and, more importantly, that the Federal Reserve and the European Central Bank will provide whatever liquidity is necessary to prevent a downside tail event such as a Spanish default. In the vernacular of the streets, the two central banks have made clear that they “got the stock market’s back.”
Regardless of how the German courts rule on the eurozone bailout fund this week (Germany's highest court upheld it on Sept. 12), ECB President Mario Draghi has pledged to buy sovereign bonds of European countries in crises. And regardless of exactly what Fed policymakers do when they meet the next two days (they ended up launching a third round of quantitative easing and extending the 0% interest-rate policy to at least mid-2015), Chairman Ben Bernanke has been emphatic that the Fed won’t stand pat. So the tail risk that’s still priced into equities in the post-Lehman bust-up is gradually coming off the table—pricing that’s best measured by the S&P 500’s forward price-earnings ratio. It’s still under 14 times earnings; given where bond yields are, it should by historical measures be at 17 to 18 times earnings.
There are other forces driving equities, as well. The U.S. is the prettiest girl (or boy) in a room of “attractiveness-challenged” global markets. While growth is subpar, its economy is not in a recession and, given recent retail sales, housing and services data, doesn’t appear headed for one. U.S. companies have shown they can make money in this blah environment—profit and top-line growth may be growing very slowly, but with input costs so low (wage inflation is nonexistent) and money historically cheap, margins are holding up relatively well. Balance-sheet wise, U.S. companies are in great shape, with lots of cash, and low, manageable debt.
So what we have while waiting for a major market-moving event—perhaps the presidential debates, the Nov. 6 election or negotiations over the looming fiscal cliff (see accompanying sidebar)—is a market that grinds higher with little enthusiasm, with money going to equities because they are the best game in town. In some ways, the U.S. equity market—and in actuality, U.S. corporations—are serving as a sort of haven amid all the global uncertainty, helping the market hold gains. Maybe investors would prefer to be elsewhere, but there are not a lot of other places they can go with confidence, so they sit it out, waiting to see if something happens to change their course.
The bottom line is the market doesn’t need a ton of growth to grind higher in this environment; it just needs continued growth and a growing awareness that a big downside event is not forthcoming. As a result, we believe it’s prudent to remain cautionary bullish, which is where we stand now in our model stock-bond portfolio, with a 40% overweight position on equities. That’s down from a larger overweight earlier this year, a reduction made in late July in part to take some profits as we close in our 1,450 target on the S&P for the year—a target that, as of this writing, is less than 15 points away. We’ll revisit our stock-bond allocations in a few weeks and will keep you posted of any changes.