With the market up around more than 10% this year, pessimists love to speculate on all that could trip it up, from a new Korean conflict to tepid U.S. economic growth to more European turmoil. Too few focus on the bigger risk: fed-up bond investors shift en masse to the stock market and overheat it.
Lately, plenty of factors threatened to trigger a correction, and thus far have not. We began 2013 with the passage of a tax bill that raised government revenue significantly, discovering that fourth quarter growth was virtually flat, corporate earnings that had only a few mild surprises to the upside and finally a two percentage point increase in Social Security taxes.
Then the sequester landed in early March, Congress used a Band-Aid to patch the government together until the end of September and Cyprus’ banking crisis made Europe nervous again.
Yet the market turned in one of its best first quarter performances since the mid 1990’s. The Dow Jones Industrial Average was up 12.02%, the Standard & Poor’s 500 10.61%, the Russell 2000 12.39%, and the MSCI EAFE 5.15%. The bond markets slowed and declined 0.13%. The Dow set several new all-time highs, and the S&P 500 finally broke through on the last trading day of the quarter.
Given all of this negative news, how is all this possible? The Wall Street maxim is “the market climbs a wall of worry,” and certainly it has plenty to worry about. Unfortunately, many investors are not enjoying this market, as the trading volume is relatively light and a lot of cash still sits on the sidelines. Many people are waiting for the market to retreat before jumping in, and it is likely a pullback will occur at some point.
No market goes straight up. A correction of 5% to 10% is a normal part of a healthy bull market. In fact, the market had 13 corrections of 5% or more since it started its upward trend in March 2009. The average pullback was 8.7%.
Last year, most of the market gains occurring during the first few months and then the market basically moved sideways the rest of 2013, with a surge during December, bringing good returns for the year. What happens if investors who remain out of the market feel suddenly compelled to jump in?
This is a great fear, but so far bond purchases have continued at a significant pace. But low rates make bond investors impatient, especially when stocks are doing so well. Should this fixed-income money loosen up and find its way into the stock market, it could cause a huge surge and cause stocks to get ahead of fundamentals.
At present, it is not. The market is selling at about 14 times earnings and historically it sells at 15 to 17 times. While risk always is in the stock market, we see much greater risk to the bond markets over the next couple of years. As the economy improves, interest rates will go up and the Federal Reserve will cease its accommodating posture of adding $85 billion of cash every month to the economy.
As interest rates rise, expect bond prices to decline, and they could do so sharply and quickly. There can always be that “unknown surprise” that throws us off balance.
But as we look forward right now, the slow growth of the last couple of years is likely to continue for the next quarter or two, with some acceleration likely occurring later this year as more people get jobs. Last year, we averaged about 150,000 new jobs per month, and this year it is running at about 200,000 per month. Should this continue, it will be a very positive sign for the economy.
That doesn’t mean, though, that no bumps will crop up along the way.
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V. Raymond Ferrara, CFP, CSA, is president and chief executive of ProVise Management Group LLC in Clearwater, Fla.
This material represents an assessment of the market and economic environment at a specific point in time. Due to various factors, including changing market conditions, the contents may no longer be reflective of current opinions or positions. It is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Please remember that past performance may not be indicative of future results.
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