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False Dawn?
Toronto: May 05, 2014
By John Stephenson

Markets in the U.S. were once again whipsawed by conflicting influences that saw them open up at the start of the session on Friday, but end the day lower in a volatile day of trading. The Labor Department’s blockbuster jobs report, which showed an outsized increase in payrolls to 288,000 in April—the most of in any month since the beginning of 2012—was no match for the negative headlines out of the Ukraine. Yet the nagging worry for investors is not the crisis in Crimea, but rather concern that the five-year bull market may be running out of steam.

The flattish returns on the S&P 500 so far this year, coupled with price/earnings ratios that look a little stretched, has many arguing that stocks are due for a pullback. That came into focus last week when the Commerce Department published their initial estimates of gross domestic product in the quarter, a mere 0.1 percent. The jarring drop from growth rates of 2.6 percent in the fourth quarter and 4.1 percent in the third quarter prompted memories of the many false dawns that have characterized the U.S.’s slow climb out from the ravages of the Great Recession.

While the S&P 500 has returned 2.6% this year when the impact of dividends are factored in, this masks the true pain that U.S. investors have experienced. In February, market leadership shifted dramatically away from high flyers, such as media and Internet names. Valuations have also contracted in consumer discretionary, healthcare and technology, while energy stocks have been the top performing sector last month, rising by 5.1%, the sector’s largest monthly gain since January 2013.

Despite these tough markets, corporate confidence is back with global merger and acquisition activity off to the fastest start since before the financial crisis. The top two industries for global mergers and acquisitions this year are telecommunications and healthcare, which together account for about 30 percent of the deal value.

Elevated price/earnings ratios are often cited as one reason for investor caution, yet at 15.2 times forward earnings the multiple on the S&P 500 is hardly out of whack with historical norms. Forward multiples on the S&P 500 have ranged from 6 to 24 times over the past 40 years, suggesting that the market multiple is unlikely to be a headwind for equity investors. In fact, bull markets end when there’s a recession, not when they get tired or long in the tooth. Seven of the last eight bull markets ended when the economy contracted, while the eighth ended because of the 1987 crash.

The road to recession tends to follow a well-worn path. A growing economy tends to burn through existing spare capacity, which results in inflationary pressure that forces the Federal Reserve into action. Markets anticipate these developments and the yield curve starts to invert (higher rates in the short-term). This leads to higher borrowing costs for consumers and business, which slows growth causing the economy to begin to roll over, taking the market with it.

But this economic rebound is the weakest recovery since the Second World War. The housing recovery is modest and business spending is still sluggish, which only serves to extend the length of the economic expansion. Housing activity has bounced back from the depths of 2009, but the rate of improvement for single-family homes in particular, has been disappointing. While multi-family home construction has picked up, this sector creates far fewer jobs and less economic activity than single-family home construction.

With capacity utilization and inflation modest and a steep yield curve, the likelihood of a recession seems very remote. For my money, I’m banking on the market snapping back in the second half of the 2014 and I am forecasting double digit gains for the S&P 500 for the next several years with the multiple expanding to 17 times or more before all is said and done.

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