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Markets Climb the Wall of Worry

Gary Black

The short-term worries that troubled U.S. equity investors in August have continued to melt away—that is, they seem to have been resolved or discounted by market participants in September. Here’s what we’re seeing:

Syria: A military conflict between the U.S. and Syria is likely to be avoided. The White House has seized upon the Putin-led proposal to allow Syria to surrender its chemical weapons, although the details are still undetermined. President Obama has a fraction of the votes needed in the Republican-led House to launch even a limited attack on Syria, echoing the sentiment of 60% of the American public who opposing a military strike. I expect Obama’s televised speech tonight will likely open the diplomacy door wider.

Tapering: The market appears to have baked in the expectation of an announcement next week that the Fed will gradually reduce its bond buying from $85 billion per month to $75 billion per month, accompanied by language that gives the Fed lots of room to reverse course if economic conditions worsen.

Fed chair: The market also looks to have discounted that Larry Summers will become the next Fed chair, rather than Janet Yellen. The announcement is likely two to six weeks out, depending on the outcome of near-term events in Syria. Former Treasury Secretary Tim Geithner has apparently thrown his support behind Summers, which has led to speculation that Yellen will withdraw her candidacy quietly.

Debt ceiling and continuing resolution: We expect Congress to pass a continuing resolution this week, kicking the can to December 13 (one week before Congress’ winter recess) and avoiding the spectacle of a Republican-led government shutdown set to go into effect on September 30. This could be accompanied by language raising the debt ceiling.

German elections: Polls indicate that Angela Merkel’s Christian Democratic party will handily win the September 22 election over Peer Steinbruck’s Social Democratic party, paving the way for Merkel to remain Chancellor for a third term. Once her party wins, we expect further softening in her European austerity language.

Other positives: Global automotive sales continue to soar; China’s industrial production, exports and retail sales are all stronger than expected; Japan’s GDP growth was even stronger than expected in the second quarter (3.8% versus an estimate of 2.6%), and a new government stimulus package to counter a doubling of sales tax is likely this month.

Conclusion
The S&P 500 Index is already up 3.0% this month, having retraced almost all of August’s 3.1% decline. We believe we are in the mid-cycle of a secular bull market, with equity earnings yields of 6.8% (1/2014 forward P/E estimate of 14.6x), providing a 380 basis point advantage relative to 10-Year Treasurys now pushing 3.0%. This 380 basis point equity premium would still rank among the cheapest 20% equity yields (relative to bonds) over the past 60 years. Putting this differently, if S&P 500 earnings grow from $110 in 2013 by 5% per year (equal to estimated nominal U.S. GDP growth over the next few years) to $125 in 2016, and long-term interest rates move up to 4%, we would expect a normal P/E multiple of 18x to 20x, based on what multiples have been over the past 50 years when long-term interest rates were in the 4% to 6% range. This would equate to an S&P level of 2250 to 2500 by 2016, and a compound growth rate of 12%, plus a current dividend yield of 2.1%, for an annualized total return on equities of 14% to 15%.

U.S. Equities: Attractive vs. Bonds

Past performance is no guarantee of future results. Source: Robert Shiller, National Bureau of Economic Research, Federal Reserve Board, Standard and Poor’s, Corporate Reports, Empirical Research Partners Analysis. 1Capitalization-weighted data.

Source for forward P/E and nominal GDP estimates: Empirical Research Partners.

The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.

Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable. The views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations.

The S&P 500 Index is generally considered representative of the U.S. stock market. Unmanaged index returns assume reinvestment of any and all distributions and do not reflect fees, expenses or sales charges. Investors cannot invest directly in an index. Price/earnings represents market value divided by expected earnings.

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