Today I’d like to talk about some important developments aiding corporate profits:
First, the U.S. dollar is near a one-year low against a broad basket of 15 major currencies, and the euro recently surged to a two-year high relative to the dollar as foreign investors continue to be big sellers of Treasury securities. Fortunately, a weaker U.S. dollar is a godsend for multi-international stocks since they are now experiencing a “currency tailwind” that is helping to boost overall corporate profits.
Second, the economic news has been stunning and despite a surge in inventories that caused third quarter GDP growth to grow at a 4.1% annual pace, more sustainable growth near a 3% annual pace is likely in store for 2014.
Third, despite the Fed’s announcement that it will begin tapering in 2014, a steeping yield curve and lingering unemployment problems will likely cause the Fed to continue with its quantitative easing throughout 2014.
Finally, the Fed has also pledged to keep short-term interest rates near 0% after easing winds down, which is essentially a “flashing light” for Corporate America to hurry up and borrow in the bond market to aggressively buyback more of their outstanding stock, which further boost corporate earnings. As a result, the total amount of stock outstanding continues to shrink despite an improving market for IPOs.
And now that the Fed announced that it will finally begin to “taper” this month by curtailing its quantitative easing to $75 billion in January, from $85 billion in December, Wall Street is expected to turn its focus away from the Fed and to pay much more attention to corporate profits.
The fact is that the Fed’s job is almost finished. The housing market and the stock market have erased all their 2008 losses and are entering the New Year with a lot of momentum—particularly as corporate earnings are now on the rise and propelling stocks higher. Earnings are expected to significantly improve in the fourth quarter and every single quarter in 2014, so I expect accelerating corporate profits to be the primary market catalyst this year.
Wall Street seems more obsessed with consistent sales and earnings growth, so stocks are characterized by big earnings surprises and moderate price-to-earnings ratios are well positioned to post spectacular sales and earnings surprises.
The other catalyst behind the stock market’s strength is what is happening in the bond market. Specifically, the 10-year Treasury bond has finally “cracked” the 3% level, which I expect will likely become the new floor for long-term bond yields. Additionally, intermediate Treasury yields have also risen substantially after the Fed announced that it would taper and there were some less than ideal Treasury auctions, so the yield curve has risen substantially.
Historically, a rising yield curve is a sign of a healthy economy and bodes well for continued stock market appreciation, since “spooked” bond investors tend to divert more money into stocks when their bond principal erodes from rising interest rates.
As a result, this parade out of the bond market into the stock market is anticipated to persist throughout 2014 and result in persistent institutional buying pressure. The fact is that there simply is nowhere else to go since the S&P 500 still yields more that 2%, which is better than the bank and dividends remain tax advantaged compared to ordinary interest income.
As any stock market moves higher, it typically becomes more narrow and selective. A “flight to quality” has been obvious in the past few months, especially as former flagship stocks like Tesla (TSLA) and Twitter (TWTR) are now stumbling a bit and are significantly more volatile.
Now, the S&P 500 has been on an impressive run without a 10% correction for a while. Rotational corrections have been happening under the surface, but a big correction is not likely until the money following into the stock market stalls.
A mini-correction in mid-February after the fourth-quarter earnings announcement season winds down is possible, but any dip should be viewed as a good buying opportunity. The truth of the matter is that I expect that the stock market should continue to “melt up” on persistent stock buybacks and inflows for most of 2014.
I have been especially pleased by the “flight to quality” that picked up in the third quarter and further accelerated in the fourth quarter. As the stock market moves higher it chases fewer stocks, so I expect that the flight to quality for fundamentally superior stocks will persist throughout 2014.
