The backdrop indicates the equity market appears to have a low probability of a large drop, but that doesn’t mean positive returns are guaranteed or that investors can be apathetic.Domestic stocks ripped in 2013 and ended the year strong. That’s great, but where do we go from here? I am firm believer that investors should focus on risk, not return. So let’s quickly analyze three risks to the domestic stock market:
- Fed tightening and rising interest rates can have negative ramifications on the equity market:
- If quantitative easing ends the reduction of “money” in the system will be small.
- The Fed will keep short-term rates very low for some time, perhaps until 2016, as labor markets and inflation remain weak.
- When longer-term interest rates rise from low levels it has been positive for stocks.
- During a recession earnings and valuations fall leading to lower stock prices:
- Currently though, the recession risk appears to be low. While we look at a variety of economic indicators, let’s focus on the yield curve as history indicates that the last five recessions were preceded by an inverted yield curve (long-term rates > short term rates):
- Valuations are too high especially given the record profit margins:
- We view intermediate-term valuations as high (Shiller PE, Market Cap to GDP, Q Ratio); however, none of these say anything about the near-term.
- Shorter-term metrics indicate we are slightly above average, but nothing alarming.
- We concede profit margins are high, but outside of rising interest rates we struggle to find a catalyst to change that.
- Further, history suggests that valuations can expand even if earnings fall unless they are at bubble levels (they are not) or a recession is on the way (see #2).
Succinctly put, when looking at the market in 2014 a low
recession risk + an accommodative Fed + non-bubble valuation levels = a market
that doesn’t appear to have a high probability of a large drop.
Having said that, there are still a few reasons for concern:
- The higher level of intermediate-term valuations indicate lower real returns over the next 10 or so years
- The above premise is wrong, in particular the impact of the Fed and interest rates
- Something unforeseen
As a result, moving forward it’s important to stay up the
quality chain, allocate to absolute return-ish strategies, look outside our own
market (international equities appear to have more attractive valuations) and
pair back exposure when the market has historically been more susceptible for a
large loss.
The views and opinions
expressed herein are those of the author(s) noted and may or may not represent
the views of Capital Analysts, Inc. or Lincoln Investment. The material presented is provided for informational
purposes only. Nothing contained herein should be construed as a recommendation
to buy or sell any securities. As with all investments, past performance is no
guarantee of future results. No person or system can predict the market. All
investments are subject to risk, including the risk of principal loss.
