The Fed Will Steal the Market's Rally By Chad Shoop, Editor of Pure Income 2014 looks to be ending on a strong note. The Dow just topped 18,000 for the first time last week. The U.S. economy grew at the fastest pace in more than a decade. And we have the broader markets closing the year with double-digit gains.
On Thursday, we will be leaving 2014 behind us, leaving us to focus on what 2015 holds.
But, as every financial analyst and brokerage firm has ever told you, past performance is no indication of future results.
So I want to warn you — the way we're ending 2014 leaves the New Year not looking so rosy …
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Many of us will be carrying over high hopes from the strong finish of 2014 into 2015. But the stock market will have a nasty trick in store for those of us remaining too optimistic about it.
That's because the U.S. stock market is sitting at an inflection point — one of expanded earnings multiples and high profit margins heading into a period of rising rates and slower growth. As a result, this inflection point will keep U.S. stocks from repeating their 2014 double-digit performance. The Heavy Hand of the Fed Let's start by explaining the Fed's role in this inflection point.
As Jeff Opdyke explained in yesterday's Sovereign Investor Daily, the Fed is on the cusp of ever-so-gradually raising rates off of historic lows. The timing is anyone's guess, but for the most part 2015 seems to be the year it will happen.
The timing is not that relevant to the inflection point, as long as it happens in 2015. The problem is that even though the rate rise will be gradual and timid, it will nevertheless be an interest-rate increase — which has many implications for the stock market.
Stocks are already at historic highs, running at rich valuations with record profit margins. For stocks to continue climbing by double digits, the price-to-earnings multiple needs to expand and/or profit margins get even fatter.
The challenge to this expansion comes from the Fed.
Whenever it decides to raise rates, investors will immediately have to discount that in the earnings multiple, because as money costs more to lend out, companies end up paying more to grow their business such as by investing in new research, new technology or equipment, or expanding their workforce. This investment eats into the bottom line, meaning investors aren't likely to see an increase in the price-to-earnings multiple in 2015 as they're forced to account for this increased cost.
Profit margins undoubtedly have downward pressure. Margins are at record levels today because corporations have focused on growing the bottom line (earnings) during this recovery — not the top line (sales). This looks great on paper as shareholders see their wealth increase, but at some point, corporations are going to have to invest capital to grow the business again.
Instead of taking out loans to repurchase shares, issue a dividend or cut staff in an attempt to take advantage from record low rates and a sluggish economy, they will be forced to invest in research and development, new products, high-level staff and new ventures.
With the added investments, profit margins are going to take a haircut.
Plus, all the corporations who leveraged up when rates were at all-time lows will begin refinancing this debt at higher rates — taking a larger piece of earnings with it.
The rally in stock prices is going to come under significant pressure from the double whammy of shrinking profit margins and refinancing burden. The Bright Spot of 2015 Thanks to the Fed, U.S. stocks are going to struggle in 2015. We are coming from a period of expanded earnings multiples and record profit margins, and going into a period of lower earnings multiples and shrinking profit margins.
That's the tone that is set for 2015. Not the "happy-go-lucky stocks are at all-time highs" euphoria that embraces the markets today.
However, hope is not lost when it comes to preparing for the sluggish market ahead. With U.S. markets set to underperform, I am looking overseas to boost returns in 2015. Those markets are deeply undervalued and haven't received the same benefit from the Fed as U.S. markets have.
Stocks in Europe are going to be buoyed if the EU enters its own quantitative easing program to boost asset prices. Russia certainly has the potential to add some volatility to the mix as we wait to see which side will blink first in this stand-off over Ukraine. And as the impact of Russian sanctions wears off, European and Russian economies will prosper again. With Europe and Russia potentially able to rebound in 2015, Asia will benefit by providing goods to those countries.
For 2015, I will be searching for undervalued, dividend-paying stocks across Europe and Asia. These stocks will generate nice returns over the coming 12 months.
Regards,
Chad Shoop
Editor, Pure Income
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