Saturday, December 27, 2014

"What If Rates Finally Rise?"

If GDP is growing at 5%, we’re adding 321,000 jobs per month, consumers are confident and spending, corporate profits are at all-time records, and the stock market is at all-time highs, one does wonder what the Fed is seeing that makes them keep their guidance at emergency low levels.
From Barron's Streetwise column:

Since 1955, stock valuations fell during initial rate hikes and mostly continued until the Fed finished the job.
The New Year brings with it hope, optimism, and, of course, resolutions—and that’s especially true for the stock market as it heads into 2015.

The U.S. economy is growing steadily—last week’s 5% rise in GDP for the third quarter was just the latest evidence, while the job market continues its march toward full employment. There are even signs that U.S. consumers might be ready to start spending like they used to, now that oil’s plunge has put some spending money in their pockets. You could say that for the first time in ages, the U.S. is starting to feel, well, normal again.

Good times for the economy, however, don’t always spell good times for the market, despite the Dow Jones Industrial Average closing above 18,000 for the first time ever last week. Remember, this bull market started in March 2009, when investors were still white with fear from the financial crisis. The Standard & Poor’s 500 has tripled since then, and while old fears may be receding, stocks are more and more priced that way, too. And that could be a problem in 2015.

At first glance, valuations might not seem so high. The S&P 500 trades at 17 times trailing earnings, in line with its 20-year median and well below the 1999 peak of 30. But the S&P 500 is a cap-weighted index, which means that its biggest stocks have a much bigger impact on the overall valuation—and when they’re cheap, it can make the benchmark look more fairly valued. And right now, those big companies look awfully cheap. Apple (ticker: AAPL), the market’s biggest stock, trades at 18 times, while ExxonMobil (XOM), its third-largest, trades at just 12.

STILL, THERE’S ANOTHER WAY to look at the market—by considering the valuation of the median or “typical” stock. And that tells a far different story. The median stock in the S&P 500 trades at 21 times trailing earnings, according to Leuthold Group strategist Doug Ramsey, some 25% higher than the cap-weighted price/earnings ratio. In 2000, the median stock traded at a 35% discount. “The average stock has gotten quite expensive, relative to the indices,” says Ramsey.

Now, just because stocks are expensive doesn’t mean they’re primed for a fall—as anyone who has ever tried to use valuation to time the market knows. Stocks could very well get even more expensive if, say, those with money to put to work decided that there’s no alternative to U.S. markets, or the world’s central banks really revved up their printing presses to juice their economies.

Sky-high valuations, however, do mean there’s far less cushion for investors if something goes wrong—and there’s plenty that can go wrong next year. Abenomics could fail to lift Japan out of deflation; Europe’s economy could continue sinking into its own deflationary mire, pulling down the global economy with it; China’s growth could continue to sputter; or the standoff with Russia could spiral out of control. Please, take your pick.

BUT WHAT IF THE BIGGEST risk is everything going right? That could be the case if the economy gets strong enough for the Federal Reserve to finally raise interest rates. Sure, that might appear far in the future, especially following December’s meeting, which resembled something closer to an exercise in close reading than one in economics after Yellen & Co. swapped out “considerable time” before rates are raised and replaced it with a “patient” approach.

Yet, despite the fuzzy language, Yellen has made it clear that rates will go up when the economic data say so. If the economy continues to grow, the job market continues to heal, and inflation, which had dropped recently because of tumbling oil, rebounds as she expects—a rate hike could be in the offing by middle of next year....MORE