This Year's Market Drivers
Seeking clues to the stock market's direction over the next year? You needn't look very far to hear some strident opinions. With that divergence of opinion in mind, today we answer three key questions about the state of the stock market.
Q Should investors worry about political action, or the lack of it?
A In the short run, yes. In the long run, not so much.
Since the November election, financial commentators have fixated on the fiscal cliff. The fiscal cliff, referring to more than $500 billion in spending cuts and tax increases that were slated to take effect Jan. 1. Without new legislation, the spending cuts and tax hikes could have combined to reduce U.S. gross domestic product by more than 3% this year. Not surprisingly, stocks jumped after a bill raising taxes on the wealthiest Americans and delaying the spending cuts for two months cleared Congress.
However, this bill doesn't solve all the problems. The last-ditch legislation permanently extends current tax rates for the middle class, addressing the most politically charged aspect of the fiscal cliff. But we expect debate over spending and borrowing policies to continue dominating headlines in coming weeks, with Republicans demanding deep nondefense spending cuts in exchange for an increase in the debt ceiling. Democrats want additional tax revenue to be part of any deal on the budget deficit. The squabbles could continue to weigh on stock prices until Congress tackles the rest of the issue. See Portfolio Review for more on the legislation.
Q Once we get past the fiscal cliff, what factors will drive stocks?
A In our view, the three factors that most affect stock prices over the long haul are corporate profits, interest rates, and inflation. In 2013, corporate profits will probably wield the largest lever.
The Federal Reserve has pledged to keep the fed funds rate extremely low until the unemployment rate falls to 6.5%, which Fed forecasts don't expect until 2015. Such a policy should help keep long-term rates fairly low as well.
Inflation could be trickier to predict than interest rates, but the Consumer Price Index has risen just 1.8% over the last year. The Blue Chip Economic Indicators consensus for December projects 2% inflation in 2013, a modest target that has held steady for the last four months.
Corporate profits are the wild card. The Blue Chip survey calls for 4.4% growth in total U.S. corporate profits in 2013, down from 6.5% growth in 2012. While the 2013 growth estimate has risen slightly in the last two months, it's down from the 5.2% expected in May and the 6.3% expected at the start of 2012.
Estimates for the S&P 500 Index are on the decline. The consensus projects profit growth of 3.7% for 2012 and 10.8% for 2013, with both targets down from those seen at the start of October and the start of July.
If the S&P 500's profits rise at double-digit rates this year, it could support strong stock-price action. But many market watchers suspect the lowered estimates are still too high.
Q How can we protect ourselves against overly optimistic profit estimates? Should we sell stocks?
A Don't sell en masse. While the estimates may be too aggressive, we can't be sure. And as always, you don't have to buy the market.
There are still plenty of individual stocks with excellent growth potential and attractive valuations. For a few examples, check out the table below. We screened for stocks with strong recent sales and profit growth, high expected profit growth in the year ahead, and economically resilient business models. All nine of the stocks in the table are currently recommended for purchase by the Forecasts.
If corporate profits as a whole lag expectations, you're better off owning individual companies that can still deliver the growth. And if it turns out that corporate America can deliver stronger-than-expected profit growth in 2013 and lift the stock market, so much the better.