01/08/2013|  David Joy

Between November 15 and year-end, the S&P 500 rose 5.4 percent. It did so primarily on expectations that a deal to avert the fiscal cliff would be struck, allowing the economy to skirt a policy-induced recession at the start of the new year. Conviction surrounding that expectation wavered in the final days, but was eventually rewarded when a partial deal was reached at the eleventh hour. In its wake, stocks rallied an additional 2.9 percent in the first three trading days of 2013. The question now is, can this rally be extended?

Certainly, some of the recent strength in equities simply reflects relief that the fiscal cliff was not triggered. But that alone is not enough to sustain a rally. If underlying fundamentals are not sound, stocks will ultimately falter. Furthermore, the relief comes in response to a deal that dealt with only part of the budget problem. There is a lot more work to do in Washington before confidence in the long-term fiscal health of the country will be restored.

So, how do the fundamentals look? In the third quarter, the U.S. economy grew at an annual rate of 3.1 percent. It was the strongest quarter of the year. If sustained at that pace, the employment picture would improve far more quickly. Unfortunately, the quarter was characterized by several business sector components with potentially troubling implications, at least in the short run. First, inventory accumulation contributed almost 1.25 percent more than in the second quarter when the economy grew at a sluggish 1.3 percent. In addition, business capital spending on equipment and software fell for the first time since the recession ended in the second quarter of 2009, representing an almost 0.5 percent difference from the second quarter. Encouragingly, job growth averaged 168,000 per month in the third quarter, up sharply from the 67,000 pace in the second quarter. But that improvement plateaued in the fourth quarter at a 151,000 monthly pace. And the unemployment rate ended the year at the same 7.8 percent rate at which it ended the third quarter.

It is unlikely that inventory growth will be sustained at its third quarter pace. Businesses will manage that carefully. But even with the recent increase, the latest inventory-to-sales ratio for October stood at a comfortable 1.29 percent, up from 1.25 percent at the start of the year, but still within the longer-term range of 1.25-1.30.

It appears that the slowdown in capital spending came in response to the uncertainty surrounding, first, the presidential election and second, the fiscal cliff. While the first of these is behind us, the second is not, and likely will not be until the end of February when the country will run out of money and its borrowing capacity must be increased. Already, negotiating positions are being staked out and the process looks to get nasty all over again. Facing such uncertainty, it is unlikely that business investment will accelerate until these issues are resolved. When they are, there is plenty of cash on corporate balance sheets ready to be put to work. But until then, that money will remain unspent. And lastly, the deal on the fiscal cliff will result in a tax increase on most Americans, creating an additional headwind. So, at least to begin the year, growth is likely to settle back to a pace closer to that of the second quarter than the third.

What about stocks? Depending on fourth quarter earnings results, the reporting of which begins this week, the S&P 500 ended the year at a price/earnings ratio of approximately 13.5x on trailing earnings. While this is not expensive, neither is it exceptionally cheap. It places stocks in middle ground, perhaps a little below the mid-point of fair value. What, then, are the prospects for earnings in 2013? According to Bloomberg, consensus expectations for the S&P in 2013 are $111. That equates to a P/E ratio on forward earnings of 13.2x based on current prices. Once again, certainly not expensive, but neither exceedingly cheap. On balance, the result is a modestly positive condition. Compared to bonds, stocks are, indeed, exceedingly cheap. And at least for now, the monetary backdrop is favorable for stocks, assuming inflation remains benign, although not everyone agrees that it will.

So, can the equity rally be extended? The answer seems to be yes, but not until we get beyond the first quarter and the outstanding fiscal policy issues are resolved satisfactorily. Assuming that occurs, capital spending should resume its growth path, to the benefit of technology and industrials. Faster economic growth would also benefit financials, as would modestly higher interest rates that follow from increasing demand for credit. Thankfully, the first round of fiscal cliff negotiations did little to harm the emerging recovery in housing, which appears now to be sustainable. It also resulted in a relatively favorable outcome for the taxation of dividends and long-term capital gains, suggesting the demand for financial assets should be firm, especially in comparison to tax rates on ordinary income. And early signs of a cyclical upturn are beginning to emerge overseas in places like China and Brazil.

Of course, a lot can go wrong. But that is always the case. The repair process of the global economy has been underway now for five years. The debt overhang, especially in the public sector remains a drag on growth and will remain so for years to come. But the private sector has done a lot of work to repair its balance sheet. Now, if we can only survive the next round of political brinksmanship, growth is likely to accelerate and equity prices are likely to climb in response. 

Important Disclosures:

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

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Contact(s):
Kathleen McClung
Manager, Media Relations
612.678.1069
kathleen.h.mcclung@ampf.com


Can the equity rally continue in 2013?
Biography
David Joy's Bio
  • Chief Market Strategist, Ameriprise Financial
  • More than 30 years of experience in the investment management industry
  • Frequent guest on CNBC, Bloomberg TV and Fox Business Network.

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