The United States stock market has risen to historic highs over the past couple of years largely thanks to the three rounds of quantitative easing of the Federal Reserve.
The stock market has tended to outgrow both the US economy and corporate profits, leading some to argue that the market might be over-valued.
The stock market could still go up another 10 percent in 2015, but investors that take advantage of this rise will need to be aware of the downside risks.
Here to me is the basic story for the stock market in 2015: what is the Federal Reserve going to do throughout the year? The foundation for the performance of the stock market over the past five years has been the quantitative easing of the Federal Reserve. The basic argument has been ”don’t fight the Fed,” or “Go with the flow of those conducting monetary policy.”
In 2015, I believe, the story will be different.
The economy has not been real great and corporate profits have not been real great, yet the stock market continues to hit new highs as it did once again on Tuesday, December 23. In terms of the first point, the current economic recovery only achieved a compound annual rate of growth of only 2.2 percent in its first five years. In the third quarter of 2014, the latest revision of the real GDP figures produced a year-over-year growth rate for the third quarter of 2.7 percent, up from the 2.4 percent recorded in the November revision of that quarter’s number.
Note: the revised GDP number that hit the press shouted out a 5.0 annual rate of growth but this was just the growth rate from the second quarter to the third quarter annualized. This methodology tends to exaggerate good quarter performances…and also bad quarter performances. Year-over-year rates of growth tend to give a more stable picture of the economy.
Corporate profits have tended to do OK, but, in my mind, they have not really shown an outstanding performance…one that could justify the overall performance of the stock market.
One way to look at this relationship is to use economist Bob Shiller’s measure of the Cyclically Adjusted Price Earnings (NYSEARCA:CAPE) ratio. In December, Shiller reports this measure to be at 27.34.
The basic idea about using CAPE is that, over time, the CAPE measure will “regress to the mean” which is in the 17.00 to 18.00 range.
The current level is nowhere near the high reached by this measure in December 1999 when CAPE reached a peak of 44.20. The S&P 500 stock index dropped in 2000 by 10.14 percent, in 2001 by 13.04 percent, and in 2002 by 23.40 percent. The next low hit by CAPE was in February 2003 when this measure hit 21.21.
Before the Great Recession, CAPE hit 27.54 in May of 2007. CAPE dropped from there and reached a trough in March 2009 of 13.32. In 2008 alone, the S&P 500 stock index dropped by 38.47 percent.
The idea here is that CAPE will eventually drop, but the timing of the decline is not certain and there is no maximum value that CAPE will eventually top out at before a decline takes place. So, all that can be said is that when the value of CAPE gets above its mean, it will eventually drop, but no one knows when it will drop or from what peak value it will drop.
So, earnings have gone up in the economic recovery from the Great Recession, but have not gone up at the same pace achieved by the stock market itself.
Here is where the Federal Reserve comes in. The basic feeling has been that the actions of the Federal Reserve, its quantitative easing, has resulted in a very responsive stock market.
In fact, the stock market has been so responsive that even in the fall, Mr. Shiller in his New York Times column alluded to the fact that the stock market might be experiencing a bit of a “bubble.”
And, as I followed up in another post:
Esther George, President of the Federal Reserve Bank of Kansas City, is getting a lot of headlines these days. More and more people are noticing that she dissented against the Fed’s ‘accommodative policy’ at seven of the eight meetings of the Fed’s Open Market Committee last year.
She is not the only dissenting member of the Open Market Committee, but she has perhaps been the most vocal and the one now gathering more attention. Her concern is that ‘aggressive lending and lofty asset-price valuations’ are evidence of ‘financial excesses’ that may cause a risk to the economy.
My outlook for the stock market? I believe that the United States stock market will continue to go up and set new records in 2015. I think that it is possible for the S&P 500 to go up another 10 percent or more, which could put it up over 2,300. A similar rise in the Dow-Jones Industrial Average could take that index up to around 18,000.
Whereas this could happen even with an economy that only rises, as I have projected, in the 2.6 percent to 3.0 percent range, I strongly believe that investors in the stock market need to be extremely vigilant. There are four reasons for this, which I will discuss below. Profits will also increase in 2015, but, in my estimation, they will not equal the profits that were achieved in 2013 and 2014. And, for these following reasons, I believe that the stock market will be more volatile in 2015 than it has been over the past several years. I think that the pickup in volatility of the past month or two has been a preview of the possible volatility in the stock market that lies ahead.
Now to the four reasons to keep vigilant. First, the CAPE measure is substantially above its historic mean. Whereas CAPE may go to higher levels, even substantially higher levels, I believe that the stock market becomes more and more susceptible to a downturn and hence will become more and more volatile as investors become more nervous. This is just a result of CAPE being in this territory.
Second, the future of the stock market will depend upon the behavior of the Federal Reserve. The Federal Reserve has put a lot of excess reserves into the banking system. Lessening the amount of reserves in the banking system will need to be done and this will occur as a part of the Fed’s efforts to see short-term interest rates move to higher levels as 2015 progresses. I have started to watch this process as closely as I can, but my advice is that investors need to give these efforts very close attention.
Third, the value of the United States dollar is going to get a lot stronger in 2015 and this fact, along with the policy efforts of many countries to get their economies on a stronger footing, may over time have a substantial impact on United States’ exports. This could hurt US economic growth more than is built into current economic projections.
Finally, one doesn’t really know yet what the ultimate consequences of the decline in oil prices will be. Several countries, Venezuela, Russia, and Iran, among others are threatened with major economic problems as a result of this decline. We don’t know yet what will be the outcome of this situation. But, serious things may happen.
In summary, I believe that the stock market will go up again next year, but an investor needs to be very aware of some of the risks that exist within the current environment. So, take advantage of the potential rise in stock prices, but be prepared to be nimble.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. (More…)
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