Stock market on track to hit 18,000 by early 2014

Posted by Shyam Moondra

In 2011, I predicted that DJIA was headed to 18,000 (“We are in a secular bull market - DJIA headed to 18,000,” The Moondra Post, March 14, 2011) and it looks like we are on track to achieve that record high by early 2014. Given that the current bull market is now more than five years old, many prominent analysts are predicting that a market crash of 10-20% is imminent. However, I believe that the bull run is not yet over.

The following trends favor a continuing up move in the stock market at least through March, 2014:

• The stock valuation is high but the market is definitely not overpriced. The forward PE of 15 for the DJIA, as currently estimated by WSJ, is by no means excessive compared to the high 20’s at the recent market peaks of 2000 and 2007. The market would look pricey if PE were to get close to high-teens, given that we are currently in a low-growth environment compared to the go-go years of the early 2000’s.

• Corporate profits continue to be at record levels, thanks to a superb job done by the corporate world in managing their cost-structure through the great recession in the aftermath of the financial crisis of 2008. Given that economy is currently strengthening (3Q13 GDP growth rate revised upward to 3.6%), further gains in corporate profits are predicted for 2014. Accordingly, there is room for continuing expansion of the PE multiples of the stocks.

• The unemployment rate has steadily come down to 7% from double-digit numbers at the height of recession, which means consumer spending would continue to increase in the foreseeable future. Also, increases in the stock prices and recovery in real estate prices have pushed the household wealth to record levels which would also guarantee increased consumer spending. Since consumer spending accounts for 70% of the economy, the economic activity would continue to be in high gear which would lead to further reduction in the unemployment rate, creating a sustainable upward spiral in GDP.

• Interest rates and inflation continue to be at low levels that always favor the stock market. In the near- to mid-term, we might see a spike in interest rates from the current 2.8% to 3.5% (on 10-year treasuries), but historically we would still be at relatively low levels. Since the corporations have a record cash hoard of the tune of $4 trillion, they may not have a huge need to borrow to support their capital expansion plans and thus the impact of higher interest rates on the economy could be somewhat muted.

• Currently, there is too much cash lying around in money market accounts and the stock market lacks euphoria which is typically seen at the market peaks (that's when stock prices go up sharply with heavy volume). That means the stocks have not yet peaked and that we would see a continued upward move in the stock prices.

• Europe and emerging markets are showing early signs of recovery after unprecedented austerity measures (taken to reduce budget deficits) devastated their economies. The U.S. recovery combined with recovery in Europe and emerging markets would give a further boost to global trade which would increase the U.S. exports and corporate profits.

• Finally, much has been made of the impending Fed tapering of their monetary stimulus program, QE3, in which the Fed buys government securities at a rate of $85 billion a month. The Fed has said that when economy improves and unemployment rate falls to 6.5%, they will phaseout monetary stimulus. The recent GDP growth rate of 3.6% makes it likely that the Fed would start tapering QE3 in 1Q14. Theoretically, QE3 tapering would have some negative impact on the stock market, but there would be some offsetting factors as well. As the interest rates increase in the face of tapering, the bond bubble would finally burst and some of the bond money would end up in stocks. Also, the underlying economy would be stronger and that means corporate profits would remain healthy. Therefore, tapering may not necessarily be a bad news and the fears of market crash are overblown.

Given the above global economic trends, there is a possibility that the DJIA might even surpass the 19,000 mark some time in 2014.

To taper, or not to taper – that is the question

Posted by Shyam Moondra

The biggest uncertainty in the financial markets right now surrounds the question of when would Federal Reserve Board (Fed) start winding down (i.e., taper) the Quantitative Easing (QE) program in which the Fed buys treasuries and mortgage-based securities at a rate of $85 billion a month. This unprecedented monetary program was designed to keep the long-term interest rates low, which, in turn, would stimulate economy, especially the housing sector. The Fed was forced to undertake this aggressive approach because the Congress and President Barack Obama were deadlocked on providing stimulus to economy on the fiscal front. The QE has had some success in giving a boost to economy via housing boom and in bringing down the unemployment rate to 7.4% from the peak of 10% at the height of the 2008-2009 financial crisis. The critics of the QE program have argued that easy money would recreate bubbles (e.g., in the housing and bond markets) and also increase inflationary pressures. While low interest rates have created a bubble in the bond market and boosted interest-sensitive stocks such as utilities, inflation continues to be in check (in fact, some fear that we may be in a prolonged deflationary environment similar to the one that Japan had during the 1990's).

Ben Bernanke, the Fed Chairman, has indicated that the goal of the QE program is to bring down the unemployment rate to 6.5% at which time the program could be terminated. The low interest rates and low inflation have boosted the equity prices; DJIA as well as the broader index, S&P 500, have both set all-time records. However, the key question now is when would the Fed start tapering the QE program. The Fed is expected to first reduce their purchases from the current rate of $85 billion a month and then start selling what they already purchased to bring down their balance sheet to more traditional levels. The whole process of tapering and selling their holdings could take years to complete.

It is generally believed that when tapering begins, interest rates would go up and stock prices would go down. The financial markets are beginning to show increased volatility as the possible tapering moment gets closer. The increase in interest yields on bonds and decline in stock prices in the last week reflect the uncertainty as to exactly when the QE tapering would begin. Bernanke is on record saying that the Fed could begin tapering when the unemployment rate goes down to 7% (currently at 7.4%). Many investors believe that tapering decision could be made as early as next month when the Federal Open Market Committee (FOMC) would meet. However, given that unemployment is still not at the level the Fed desires (next unemployment report is due on September 6, 2013) and inflation continues to be within the Fed's target range, the FOMC may decide to defer the decision on tapering to their next meeting in December. If a decision is not announced after their September meeting, the stock markets could soar to new record high and long-term interest rates could get a reprieve from recent run-up.

Given how sensitive financial markers are to the timing of tapering, it may be better if the Fed pulls back from its recent policy of transparency and not be so open on what their plans are. Below are some principles that the Fed could adhere to:

• Tapering and unwinding of their balance sheet should be done in a very gradual fashion, spread over several years. This would minimize severe volatility in the financial markets.

• The Fed should bring their transparency down a notch and not talk about their plans publicly. They should not pre-announce when they would begin tapering and at what rate. If investors don't know, they wouldn't react and that will help minimize volatility and reduce chances of flash crashes in the financial markets. If the Fed tapers gradually without public fanfare, it's possible that it might have very little negative impact on economy, to the point that people might not even notice that taper has already begun.

• The Fed should give out information on tapering and unwinding of their holdings after the fact and only in less dramatic way (e.g., making a vague reference in their meeting notes rather than Bernanke talking about it prominently at a press conference). The less the information given out in a low-key fashion, the better it would be.

Regardless of what the Fed decides on unwinding QE, the long-term prospects for the stock markets continues to be positive. Yes, the interest rates would increase, but given we are so far down from the normal interest rate levels that existed prior to the financial crisis of 2008, one should exercise caution in not overstating the impact of rising interest rates. In any case, given record cash hoards on the corporate balance sheets, their capital expansion plans may not be negatively affected by higher interest rates. Second, the end of QE would also signify significant improvement in the job market, which means increased consumer spending. Since consumer spending accounts for two-thirds of economy, corporate profits would increase even more from their current record levels. Also, higher interest rates would finally burst the bond bubble and some of that money would end up in stocks. Therefore, the recent decline in the stock prices caused by uncertainty surrounding the timing of tapering, could in fact be a good buying opportunity for the long-term investors.