A number of macroeconomic events are bringing equities to a strong year-end close. The most important is American GDP growth, which was expected to rise by 3.3% in the third quarter. This number was revised upwards on Tuesday as the BEA saw “positive contributions from PCE, nonresidential fixed investment, federal government spending, exports, residential fixed investment, and state and local government spending that were partly offset by a negative contribution from private inventory investment.”
In other words, people are spending more (PCE), companies are investing more in large machinery, real estate, and other investments that will increase production (fixed investment), and government spending. The only negative was private inventory investment. This, combined with the fixed investment spending, suggests that companies are expecting demand to increase in the longer term more than in the shorter term.
A number of sectors are likely to benefit from this growth, particularly retail (XRT) and consumer discretionary (XLY). More broadly, the rising investment in greater consumer demand will help the S&P 500 Price/Sales ratio (SPY), which has risen to very high levels, historically speaking, which has caused some investors and pundits to fret about a bubble.
Looking at another metric, the S&P P/E TTM ratio has risen to above 20, a significant resistance level that proved an impossible hurdle for all of 2014.
The forward looking P/E ratio is much lower, depending on which estimate you look at. According to Birinyi Associates and the Wall Street Journal, the forward SPY P/E ratio is 17.05. If that proves correct, the S&P 500 can rise to 2429 before it hits a TTM P/E ratio of 20, which is over 17% above its current level. If earnings continue to grow as they have done in 2013 and 2014, that shouldn’t be impossible; if it does better, as businesses are anticipating with their investments, then that 2429 could be surpassed even sooner.
This is one sense that many investors and traders are getting from the GDP numbers, although macro traders fret that improving economic conditions could cause the Federal Reserve to raise interest rates sooner, which would hurt stocks badly. Hence the U-shaped pattern that the market took on Tuesday after the results were made public; bottom-up optimism met top-down concern, meeting somewhere in the middle.
While the market’s response to the GDP beat has been lukewarm in aggregate, a lack of volatility indicates there is little fear in the market of a steep downturn. The VIX stayed well below 13, and remained in a downward trend after the mid-October spike. If investors worry that easy money will not puff the sails of stocks, they are not worried that rising rates will cause a major bear downturn, either.
Now investors will need to decide exactly how much they trust this improving economic indicator and choose where the gains will be seen. Tech is underperforming after the announcement, with many momentum stocks (NFLX, P, TWTR, FEYE) struggling on an otherwise cheery day. While QQQ is slightly above SPY, small caps (IWM) are negative and large caps (DIA) are positive, suggesting that investors are better on high broad growth but not on high risk per se.
Janet Yellen should be pleased. The Fed Reserve Chairman has publicly fretted about overvalued momentum stocks and the need for markets to move on fundamentals and not on monetary policy. Today’s rise, fall, and rise again can be seen as a transition in which fundamental investors bet more aggressively on fundamentals than the macro traders bet on monetary policy. If this continues, Yellen may be embolden to become far less interventionist in the coming months, bringing fundamental trading back into vogue in 2015.