Momentum certainly looks to be king right now, with the stock market about to post its single best annual return seen since 1997, in the midst of the “glory days” for U.S. stocks. As you sit down for some turkey this week, that’s something for which to be thankful.
Had you asked any market veteran what kind of gains they expected from stocks back in January, odds are high that, after the typical “on the one hand; on the other hand” analysis and the usual caveats, they would have suggested a 10 percent rally in the S&P 500 might be the biggest we could looked for in 2013. Instead, with less than six weeks left in the year, we’re sitting atop a nearly 30 percent return and busily climbing that proverbial wall of worry once more.
Nor is the rally over, some suggest. Goldman Sachs, for one, has just produced a forecast that by year-end the S&P 500 will have rallied still further, to hit 1900. After that, its team of economists and other big thinkers say that it’s full steam ahead, as growth in the economy spills over into higher sales and corporate earnings, helping to justify some of the expansion in price/earnings multiples that we have witnessed this year.
Until about a year or 18 months ago, stock market bulls would have argued that the S&P 500 and other market indexes were lagging behind improvement in corporate profits – and they would have been right. In the last year, though, that pattern has flip-flopped, as earnings growth (while consistent) is in the low single digits and revenue growth in many quarters remains flat to non-existent.
Nonetheless, in the wake of this year’s rally, the S&P 500 is trading at about 15.4 times earnings, meaning that investors are willing to pay $15.40 for every $1 of earnings reported by companies in the index. That’s a healthy premium to the 10-year average of $14.1 per $1 of earnings, or to the 35-year average P/E ratio of only 13. In other words, investors have allowed themselves to be carried away by the market’s momentum, bidding up stock prices in anticipation of future growth in profits.
A body in motion will remain in motion until it is acted upon by some outside force. That’s the first of Sir Isaac Newton’s three laws of motion, and the question now is what kind of “outside force” will step in to cause the current stock market momentum to halt in its tracks. The other alternative to worry about relates to Newton’s third law of motion: “for every action there is an equal and opposite reaction,” suggesting that any abrupt change in market sentiment could precipitate a market plunge that would wipe out a chunk of the gains we have seen this year.
Momentum-driven stock markets can be tricky to navigate, as Jack Ablin, chief investment officer at BMO Harris Bank, noted in a recent letter to clients. That is in part because at some point along the way, a momentum-driven rally becomes a self-fulfilling prophecy. Investors begin to view the market’s outperformance as a validation of their decision to overweight stocks and put still more chips on the table.
As the Newtonian laws suggest, momentum-driven rallies can endure for a while – or at least, until they encounter some external force, whether in the form of an economic shock or if the anticipated growth in earnings or profits fails to materialize. Perhaps the biggest factor keeping this particular momentum-driven bull market intact at the moment is liquidity.
Ablin calculates that inflows into stock mutual funds this year have totaled $27 billion, while investors have thrown another $107 billion into stock-based exchange-traded funds. Russ Koesterich, BlackRock’s investment strategist, has noted that those flows are starting to abate somewhat and suggests that “the magnitude of the recent rally has prompted some investors to engage in some selling and profit-taking.”
Nonetheless, the Goldman Sachs analysts estimate that there will still be $150 billion in demand for U.S. stocks, with buybacks of $450 billion and mutual fund and ETF buying of $300 billion offsetting selling by households and individuals as well as overseas investors (as the dollar and interest rates creep higher along with valuations).
If you’re looking past Thanksgiving and seeking an edge in the market for 2014, the Goldman Sachs wizards suggest you emphasize growth over value, hunt out companies that should see an immediate return from an uptick in capital spending, like Marathon Oil (NYSE: MRO), Humana (NYSE: HUM), Oracle (NASDAQ: ORCL) and Dollar Tree (NASDAQ: DLTR) as well as those that have a high degree of operating leverage that will profit from higher sales like Safeway (NYSE: SWY), Autodesk Inc. (NASDAQ: ADSK), Boston Scientific (NYSE: BSX), Expedia (NASDAQ: EXPE) and Yahoo (NASDAQ: YHOO).
Finally, look for companies that are actively buying back stock – that’s a strategy that doesn’t rely on further expansion of the price/earnings multiple to generate a real return for shareholders. (Some of the stocks the Goldman Sachs team identifies here include Viacom (NASDAQ: VIAB), Tyson Foods (NYSE: TSN), Coca-Cola (NYSE: KO), Ameriprise Financial (NYSE: AMP) and Tenet Healthcare (NYSE:THC).)
By any historic measure, today’s market valuations are stretched, if not yet to the breaking point. But history suggests they can stay that way for weeks, months and even years. Ablin notes that in years that followed blockbuster stock market returns of 20 percent to 40 percent, the average annual return has hovered at around 11.4 percent. “It appears that there is little correlation, if any, between one year’s return and the market action the next year,” he comments.
There is, however, a link between that outsize return and investor behavior in the following year. Sure, if you sell, you may be leaving money on the table. But before you decide to let your chips ride, you might want to ask yourself just how comfortable you are in a market driven by momentum rather than fundamentals.
Top Reads from The Fiscal Times:
