Despite the some recent fluctuations, major U.S. stock indices like the S&P 500 Index (SPX) and Dow Jones Industrial Average (DJIA) markets are still setting record highs.
On July 14, Goldman Sachs (GS) revised its year-end target for the S&P 500 to 2,050, up from the previous target of 1,900. Against the backdrop of the U.S. Federal Reserve’s accommodative monetary policy, strong corporate earnings, and improving job markets, individual investors are plowing money back into the U.S. stock markets.
About $100 billion has been added to equity mutual funds and exchange-traded funds in the past year, ten times more than the previous 12 months, according to data compiled by Bloomberg and the Investment Company Institute.
At Julex, our quantitative model still indicates “risk on” and a continued bull market. Although no significant risks are imminent in the market now, investors should be mindful of four things that could derail market rallies.
Rising Interest Rates
After the Fed ends its quantitative easing bond purchases in October, the timing and path of rate increases will present uncertainties in the markets. If the Fed raises interest rates slowly in an orderly fashion like the last tightening cycle, the market rallies may continue for a long while.
Should the Fed raise rates in a hurry to fight potential inflation threat, it will be hard for the market to digest and significant market corrections may occur. We believe that the slow rise in interest rates is more likely scenario, but it will be data dependent. The unemployment rate and inflation rate are the most important data for the Fed to determine the course of action.
Subpar Revenue Growth
With forward P/E of S&P 500 Index at 15.6, which is higher than the ten-year historical average of 13.8, the room for further expansion may be limited. To support the continued bull markets, corporations need to continue growing revenue.
In recent years, corporations have achieved earnings growth by cutting costs. However, with profit margin at historically highs, it becomes hard to expand margin further.
Revenue growth has a lot to do with economic performance. The US economy is doing better, but it’s only growing at a 2% or so annual pace. Robust revenue growth cannot be supported by subpar economic performance. We do think the US economic growth will pick up, but it is still questionable how robust it will be.
Fragile European Banks
Europe still remains a risk to markets. Worries about a major lender in Portugal recently sent U.S. stocks on an early swoon after Banco Espírito Santo International delayed coupon payments relating to some short-term debt securities. On July 18, the lender’s parent company, conglomerate Espírito Santo International SA, filed for creditor protection.
Although the Europe just crawled out of recession, the recovery is still fragile and its banking system is still fragmented, especially in Portugal and Greece.
Middle East Tensions
Rising tensions throughout the Middle East and potentially higher oil prices are also risk factors. Egypt has regressed to military rule, Syria is still mired in a civil war, and the extreme group, ISIS, seizes city after city in Syria and Iraq.
There are more potential disruptions of oil supply here. As oil prices are already creeping higher, any further disruption in production would likely send them higher. Increasing oil and gasoline prices would represent a painful blow for consumers and the global economy. In general, a $10 increase in the price of oil cuts 0.2% to 0.3% from GDP.
Qualitatively and quantitatively, we still believe we are in a continued bull market and “risk on” regime and have our managed portfolios positioned accordingly. The four economic and market factors we are tracking are all point to a positive risk-taking environment (see graph below). However, investors need to be aware of the potential risks in the markets.
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DISCLAIMER: The investments discussed are held in client accounts as of June 30, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.
