Portfolio allocations depend on fundamental value and macroeconomic conditions. While financial analysis can help analysts identify unique and undervalued assets from the bottom up, portfolio managers need to be aware of macroeconomic conditions that can impact investments from the top down. As we sit between earnings seasons, many analysts are looking at macroeconomic indicators to get a sense of exactly where this bull market is going.
There are plenty of indicators to look at, but the most significant is GDP. After falling in the first quarter, an annualized growth rate was needed to ensure that the U.S. is not slipping into recession, and first estimates indicated that a 4% annualized growth rate would be enough to keep the U.S. in positive growth territory. More recently, that GDP number was revised upwards to 4.2% in the BEA’s second estimate.
GDP growth is significant because they correlate with the largest drawdowns in the S&P 500 (SPY). Unfortunately, the SPY declines usually precede the negative GDP growth. The U.S. GDP grew at 3% and 2.7% in the first two quarters of 2008, and even the third quarter saw 1.8% growth, after the S&P 500 had begun the biggest correction in a lifetime.
Those who rotated out of stocks before the decline in GDP avoided the greatest stock market crash since 1929, but those were few and far between. At the time, positive GDP growth was enough to keep people engaged in the market and exposed to equities. Now, identifying a slowdown or acceleration in GDP growth is important to determine exactly how much equity exposure is safe, and how much risk-adjusted returns investors can expect.
Another important point is psychological: the S&P 500 has been on a steady upwards march for 2014, except for three minor and short-term corrections that are getting shallower and shallower. After correcting in the beginning of August, the index has reversed back into a bullish trajectory. That’s lead the index to cross 2000 for the first time in history, but it has so far failed to sustainably cross the threshold.
While the number has no real economic or financial meaning, it is an important psychological barrier that bulls and bears can point to as a watershed moment. Therefore, crossing or not crossing is a significant matter for investors.
While the 2,000 number is making headlines, a less noticed but arguably more important number is also reaching a round point: the S&P P/E ratio has remained well above 18 throughout 2014, and has been above 19 all summer. With the most recent bull run, the S&P P/E ratio is close to hitting 20. While the number has limited significance on its own, it is a symbol of a bullish, or even bubbly market. Crossing that threshold will be much harder for the S&P 500 than 2,000, because anything above 20 will remind investors of the lofty late 1990s, when the P/E ratio was ignored and absurd metrics like clicks on a website became indicators of value in a bubble that the Nasdaq (QQQ) has still failed to recover from. Also significant, the S&P 500 P/E ratio has a historical median of 14.56, meaning we are 36% over the historical norm when it comes to stock value.
Finally, there are risk factors that have kept investors cautious, if not fully pessimistic. Russia and Ukraine have had an impact on stocks that have no exposure to the region, although their impact is getting clearly more muted. Falling property values in China and slowing growth are leading some investors to fret that the growth driver that has propelled many U.S. companies, like Yum Brands (YUM) and Apple (AAPL), may be less reliable than previously assumed. The Federal Reserve’s QE program is ending in two months, which could tighten monetary policy too much. Germany and France may be in a recession; Italy already is. And, of course, demographic pressures, stagnant incomes, and tapped-out consumers are other worries that can provide systemic risks in all economies.
When analyzing these factors and concluding whether the macro environment is favorable or unfavorable, investors should be careful about reaching for a clear conclusion. While risk factors remained much lower in 2013, thanks to a generous loose monetary policy from the Fed that helped all assets except bonds, this year is a transition in which the Fed’s famous “training wheels” are coming off. Now we need to see if the economy can survive on its own, without central bank support. For the rest of 2014, investors will be able to choose exactly how confident they are in an economic recovery that has so far been slow but consistent.