Rally Stalls Amid Fed Doubts


After surging to all-time highs Sept. 18 when the Federal Reserve unexpectedly kept its bond-buying program intact, U.S. stocks have stalled amid doubts about the implications of the Fed's move. Some argue the Fed has undermined its inflation-fighting credentials, while others worry that the Fed's expectations for the economy have deteriorated.

Also weighing on sentiment are the budget and debt-ceiling battles in Washington. While most do not expect a government shutdown or debt default, nearly all agree a return to the brinksmanship seen in the 2011 debt-ceiling debate could unnerve investors and consumers. No later than Oct. 17, the Treasury Department says, the U.S. will be unable to pay its bills unless Congress raises the debt ceiling.

Bond yields have dropped sharply since the Fed's decision, reaching a one-month low of 2.6%. Rate-sensitive utility stocks have outperformed since the Fed's decision, while financials and other cyclicals have mostly underperformed. Still, the economically sensitive Dow Transports are less than 2% from all-time highs, as is the Morgan Stanley Cyclical Index.

Consensus profit estimates have moved little over the past month, with per-share earnings for the S&P 500 Index expected to be up 4.7% for the September quarter, 11.1% for the December quarter, and 11.4% for full-year 2014. In fact, expected year-ahead earnings for the large-company S&P 500, S&P 400 MidCap, and S&P 600 SmallCap indexes reached all-time highs on Sept. 19, according to Yardeni Research.

At roughly 15 times expected year-ahead earnings, the S&P 500 remains reasonably valued relative to historical norms and quite cheap relative to bond yields. But year-ahead earnings estimates reflect expectations of faster revenue growth and improved profit margins, and in our view a speedy return to double-digit profit growth seems unlikely.

Moreover, the P/E ratio of the capitalization-weighted S&P 500 Index is being skewed lower by the modest valuations of its biggest members. The median stock in the broad S&P 1500 Index trades at 19.8 times trailing earnings, above the 19-year norm of 17.8 and higher than 87% of month-ends since October 1994. The median price/sales ratio of 1.7 is the highest on record since October 1994.


The Dow Industrials, Dow Transports, S&P 500 Index, and most major averages reached fresh highs on Sept. 18, and the primary trend is squarely in the bullish camp under the Dow Theory. But stocks are no longer cheap, so improved earnings growth may be needed to fuel meaningful gains. Our buy lists have 94% to 98% in stocks.

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