Stocks have managed to soar for nearly six years with the U.S. recovery merely sputtering along with frequent pauses. So what might the market be able to do now that the American economy appears ready to hum?
Not all that much, maybe.
Wall Street celebrated the pleasantly surprising November payroll report Friday that showed a gain of 321,000 jobs, with quickening of wage growth. And, indeed, the market had already been lifting consumer stocks in anticipation of a pickup in domestic spending, as employment grows and gasoline prices shrink.
Jefferies & Co. market strategists note that Americans’ household net worth has never been as high as current levels at a time when the “misery index” of unemployment plus inflation has fallen toward “decade lows,” as it is now. Here we have the makings of a “new story” that could animate the bull market into next year, as discussed here recently.
Yet investors and companies have arguably front-loaded domestic stock-market returns during this bull market, by milking high profit margins and using cheap debt to fuel share buybacks.
This could mean that we’re in for a phase when Main Street outperforms Wall Street for a stretch, as companies pay up for workers, multinationals contend with sluggish growth overseas and we approach the long-awaited first interest-rate hike in more than eight years. The share of U.S. output going to private-sector profits is near a multi-decade high with labor's share around post-World War II lows. With worker earnings finally (and perhaps tentatively) starting to climb, this spread should move in reverse.
The stock market’s head start against the “real economy” can be viewed in these charts of total equity market capitalization to U.S. gross domestic product. This measure was below 60% at its most washed-out level in early 2009, but has since catapulted to nearly 120% - higher than at any point aside from the peak of the Nasdaq bubble in 1999 and 2000.
For sure, stocks have been largely supported by record-high corporate profits, of which a record proportion of nearly 40% are earned outside the U.S. This somewhat mutes the utility of comparing big American stocks only to the U.S. economy.
Still, faster domestic growth - which has helped drive a spurt in the value of the U.S. dollar against most other currencies and is expected to prompt the Federal Reserve to begin lifting rates before other big central banks in 2015 – complicates the low-growth/high-liquidity interplay that has enriched investors since 2009.
Goldman Sachs strategists, meanwhile, are looking for meager upside in the S&P 500 over the next year with a target of 2100, up just 2%, even as the firm sees the U.S. economy accelerating nicely. While Goldman grants that if interest rates don’t rise much a target of 2300 might be merited, the broad view of a stoutly valued market remains.
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The standard Wall Street line is that stocks can do just fine as the Fed begins tightening when it’s for the “right reason” – better growth, and not rising inflation. While true, some nervous adjustment period often intervenes. Can we segue smoothly from a climate when “bad news” was often welcomed as a reason for more easy money to one where “good news” such as climbing wages is emphatically embraced?
An unbalanced world
October’s nasty market sell-off on global-growth concerns and the notion that the Fed was determined to tighten anyway shows that psychology could stay fragile for a while when it comes to Fed policy.
Wells Capital Management strategist Jim Paulsen raises another potential impediment to U.S. stocks’ reaping the full benefit of a sprightly Main Street economy: Everyone is already expecting America to outperform. U.S. stocks and the dollar have already vastly outperformed the rest of the world and are more expensive than other developed and emerging markets.
Crowded trades rarely follow the expected script. With nearly everyone parroting the cliché that the U.S. is “the best house in a bad neighborhood,” it’s worth a reminder that real estate experts will tell you this is exactly the house one shouldn’t buy.
Related: Job report strongest in almost three years, how will Fed react?
Paulsen’s point is that with everyone piled into U.S. stocks and the dollar, heavy stimulus in Europe, Japan and China combined with cheaper stocks could mean foreign stocks catch up to stateside equities in 2015.
At minimum, too, the below-the-surface drivers of corporate profits and investor returns could mean a trickier trading environment even if the U.S. economy meets current rosy expectations next year.
The brutal sell-off in energy-related stocks and bonds, triggered by the nasty spill in oil prices, highlights that North American petroleum production has consumed an oversized portion of new debt and capital-investment dollars undertaken by American business. More broadly, low-grade corporate debt yields have been creeping higher, weakening one important support for other risky assets such as stocks.
Meantime, the dramatically unbalanced setup for global growth - sturdy U.S. growth driving a strong dollar and the threat of higher rates, against flat-lining economies and aggressive central bank stimulus elsewhere - is hastening rapid capital flows of the sort that can undercut financial-market stability without seriously threatening the Main Street economy. Tuesday's sell-offs in China and Greece on growth and policy concerns are a reminder of world markets' vulnerability to sudden "dislocations."
Emerging-market debt and currency weakness and the upending of popular currency trades harken to the twitchy capital-market panics of 1997 and 1998 - late-bull-market years when markets underwent severe volatility along their upward path, even as the American economy plugged along nicely.
Too early to worry?
There’s a chance this whole idea of Main Street stealing the spotlight from Wall Street is too clever by half – that before we get to a point where investors suffer while consumers prosper, we are perhaps entitled to a phase when it all gets better together and the “obvious” thesis of U.S. ascendancy rewards both camps.
Related: Investing in 2015: Why timing is everything
Current market leadership groups – consumer discretionary, financials and technology – reflect a pretty healthy market with a resemblance to the 1990s boom years. While the market is, on average, pretty expensive, valuations are not far out of whack for this stage of the bull cycle and a jolt of top-line growth next year could make them pretty unchallenging.
Finally, each time in the past two years that this market has reached a key juncture, it has chosen the path of more upside to settle the argument among conflicting signals. Maybe this implies the market still deserves the benefit of the doubt.
But it shouldn't come as a surprise if the market fails to celebrate every glimmer of good news for the the Main Street economy quite as avidly as it has the sluggish but heavily medicated recovery of the past few years.