US Quarterly Review & OutlookSubmitted by Castlebar Asset Management on October 9th, 2012
Stocks brushed off a sluggish second quarter to move ahead over the past three months. Markets were helped when the Federal Reserve (Fed) announced their newest round of monetary policy dubbed “QE 3”. In the third quarter, the S&P 500 added 6.35% while the NASDAQ popped 6.53%. Both markets have had an excellent year with the S&P 500 rallying 16.44% and the NASDAQ surged 20.72%. This year’s performance has surpassed most on Wall Street’s expectations.
Looking ahead we are cautiously optimistic that stocks should maintain their gains through the end of the year. Housing has shown signs of recovery and the Fed remains accommodating with its monetary policy. This bodes well for stocks. With that being said there are a few headwinds that could pose a problem in the “Fiscal Cliff” and what is expected to be a transitional earnings season.
Housing is slowly recovering from its doldrums. The Case/Shiller Index, a respected measure of housing prices across the US, showed that home prices are recovering and prices around the country are expected to post a 2.5% gain this year. More robust returns are expected in 2013 and 2014. Economists are predicting that housing will once again contribute to economic growth. This the first time it has added to US growth since 2005. This is a promising sign for the US economy because historically housing leads the US economy out of weak periods.
There is a saying in the investment community “Don’t fight the Fed.” This saying explains that when the Fed want to make markets rally or cool the economy off it has the power to accomplish this through their monetary policy actions. As mentioned above, QE 3 was announced in September and the Fed will buy up to $40 billion in mortgage backed securities per month with an open end date. The Fed also has signaled they intend to keep interest rates low, at or near 0%, until the middle of 2015. With these actions the monetary policy arsenal has been all but emptied. The Fed plans to keep rates low and bond buying going until they see a material decrease in unemployment. Unemployment is currently around 8% and they will likely keep the spigots open until it is between 5% and 6%.
The fiscal cliff, the name given to the automatic budget cuts and tax increases put into place by the Budget Control Act of 2011 could go into effect on January 1st. These budget cuts and tax increases would have a negative effect on economic growth. Some estimate that it could reduce growth by 2% to 5% which would put the US into a recession. The likelihood that Congress lets these cuts become law are pretty low. We expect Congress to punt on this issue and push any changes back 6 to 12 months but given the lame duck session we believe it could come down to the final days before Congress goes home for Christmas. Last summer the debt ceiling debate in Congress caused stocks to sell off and the US to lose creditability with credit agencies. A similar reaction is possible if the fiscal cliff issue is dealt with in a similar manner.
The S&P 500 looks to be fairly valued at current levels. It is trading at 13.8x 2012 earnings estimates and this is in line with the S&P 500’s five year historic average. The market is a little rich looking at 2013 earnings. It is trading at 12.4x forward earnings which is above the 11.9x five year forward average. The broader market rarely hits fair market valuation and then moves sideways. In our experience it usually rallies from these levels.