It’s Not All About the Fed

No sooner had the least loved U.S. equity rally in memory finally gained some admirers, volatility returned to the markets. To the skeptics who finally dipped their toes back into risk assets, the recent market swings may have felt as if they’d bought at exactly the wrong time. And yet nothing fundamental has changed, except that the Federal Reserve has optimistically indicated that a strengthening U.S. economy will allow them to slow their asset purchases a quarter or two earlier than previously expected. I suppose I understand the concerns of market participants who subscribe to the notion that the rally has been entirely an ephemeral, Fed-induced windfall, but I don’t share that opinion.

The Fundamentals Are Sound

I see sufficient fundamental strength to justify the market’s 2-year upward trend. Earnings have doubled over the past five years while valuations have only climbed by slightly more than half. As you can see from the chart at the bottom, the rally of the last two years has been about stocks catching up to those fundamentals, from the oversold conditions reached at the height of the debt ceiling debacle in 2011 to the generally fair valuations that they maintain today.

Bull markets typically don’t end at fair valuations. Given today’s still-low interest rate environment, the general strength of Corporate America and an underappreciated favorable demographic mix, stocks are likely to ultimately surpass recent nominal highs. Investors have been clamoring for a market pullback, and Fed Chairman Ben Bernanke’s words have now delivered one in a way that President Obama’s reelection, the fiscal cliff compromise, and the sequester couldn’t. I can only hope that advisors’ phones are ringing.

Fed Tightening Still Well Off in the Future

If the Fed’s goal in announcing a swifter tapering of asset purchases was to avoid a rally becoming yet another asset bubble, they may have succeeded. The pendulum has now swung from concerns that the Fed will stay loose for too long to fear that the Fed will be too quick to tighten. Such concerns are likely to be very premature. Given the current run rate in nonfarm payrolls, the economy is still nearly two years away from the Fed’s targeted 6.5% unemployment rate. Stable aggregate prices and no effective wage pressure mean that inflation is unlikely to force the Fed to tighten soon. The market’s reaction—higher interest rates, cheaper stocks—has, itself, already tightened financial conditions, providing the Fed with more room to keep policy loose. I believe treasury rates are unlikely to rise significantly from here, and short-term interest rates are likely to remain low for a long time.

Normal Road to Normalization Not ImminentSource: Federal Reserve Bank of Atlanta as of 5/31/13. The calculator assumes labor force participation of 63.3% and average monthly population growth rate of 0.07%. Projections may not be achieved

A close look at Fed comments reveals that Bernanke isn’t exactly bullish on the economy but rather less pessimistic. I think the exact quote heard around the world was, “the fundamentals look a little better to us.” The Fed Chairman was not telling us anything that we don’t already know. On one hand, the U.S. economy has some tailwinds. The rebound in the housing sector is supporting not only construction jobs but also greater household wealth, which in nominal terms is back above its pre-recession high. Oil and natural gas production are at levels not seen in a couple of decades. Deficits are shrinking and commodity prices appear to have peaked. Most of the downside risks appear to be either receding (U.S. fiscal issues) or — for the time being — being managed (Euro crisis).

But with apologies to President Truman, there are no one-handed economists. On the other hand payroll growth is underwhelming and, with the relative weakness of many of the trading partners of the U.S., industrial production is about as flat as the table at which I sit. Notably, Chinese policymakers appear to be willing to accept less growth to deflate potential asset and property bubbles. Even a “sluggish” China, the world’s second largest economy, will still add some $500 billion in incremental global output, but the rate of change matters particularly for other emerging market economies whose prosperity has been tied to Chinese growth. Markets have already turned China’s deceleration into sizeable emerging market equity discounts to the developed world’s valuations. With political tensions rising in key countries, sovereign bond markets have followed suit.

Expect Less, But Stocks Are Still Attractive

Paradoxically, equity returns were already likely to moderate as the U.S. economy picked up the momentum that the Fed now envisions. Why? As business investment and employment accelerate, profit margins in general decline. Successful businesses will make money by selling more of the products and services that global consumers demand rather than by squeezing more profit from each item sold. It may sound cliché but investors will have to be more selective. Equity leadership will likely shift from the higher yielding and more defensive names that have led the rally to more cyclical companies that can benefit from improving growth.

For investors, the road from a policy-driven to a fundamental-driven market might remain a little bumpy. Regardless of how the much anticipated pullback plays out, however, I believe selective holders of equities will likely be the long-term beneficiaries.

Fundamentals are Better than at Prior Highs
1.Earnings per share (based on trailing 12 months of Operating Earnings) measures the amount of operating earnings (which are earnings derived from actual business operations and not financial transactions) generated by companies in the S&P 500 Index over the past twelve months. Earnings data is as of Q1 2013 (3/31/13)
2.The Price to Earnings Ratio measures the valuation of an index by measuring the price paid for each dollar of earnings by the companies in the S&P 500 Index
3. The Price to Sales Ratio is another valuation measure that examines the equity price paid for each dollar of sales by the companies in the S&P 500 Index
4. Dividend yield is the amount of cash distributed relative to the price of a security and may be used as a valuation metric to determine relative value of a security or index
5. Cash and Short-Term Investments are a measure of balance sheet stability. Cash and Short-term investments are considered very liquid and may be used for a variety of functions for the companies in the S&P 500 Index.
6. The Cash/Asset Ratio measures the percentage of cash on a balance sheet relative to the total asset base. This may indicate the leverage and stability of a company.

Source: Ned Davis Research as of 4/30/13. The S&P 500 Index is a market-capitalization weighted index of the 500 largest stocks in the United States. Index is unmanaged and cannot be purchased directly by investor. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. There is no guarantee that the issuers of stocks held by mutual funds will declare dividends in the future, or that if dividends are declared, they will remain at their current levels or increase over time. Past performance does not guarantee future results.

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Past performance does not guarantee future results.

Mutual funds are subject to market risk and volatility. Shares may gain or lose value. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes and political and economic factors. Investments in emerging and developing markets may be especially volatile.

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