The stock market really should be in decline right now, but there’s a good amount of hope out there—hope that central banks will make things better. Of course, there’s really nothing that the Federal Reserve can do for the U.S. economy, and the situation in the eurozone is all about confidence. The reason why the equities market should be declining is that the earnings outlook is declining, and that’s right from the mouths of corporations.
Yet the equities market is holding up incredibly well, and this is particularly the case with technology stocks and the NASDAQ. If you pull up a 30-year chart on the NASDAQ Composite and exclude the bubble in the late 1990s, the trendline is remarkably intact. Historically, the NASDAQ Composite looks like it should be where it is now.
And if we look at the Dow Jones Industrial Average, this equities market index has now made a full recovery from the last U.S. recession and the subprime mortgage meltdown that almost killed the stock market. The Russell 2000 smaller-cap index has also recovered fully from the stock market low in 2009. The extreme volatility has been in the S&P 500 Index, which has yet to recover to its stock market highs from 2000.
Even though the earnings outlook is declining, reasonable valuations in the equities market are helping keep share prices aloft. If we get more stability—both politically and economically—from the eurozone and some form of confidence-building action from the Federal Reserve, I actually think the S&P 500 index can break 1,400, which, combined with dividends, would make for a pretty decent year on the stock market. (See “Corporate Profits Meet Expectations—Stock Market Action Positive.”) Election years have a way of doing this.
The downside risk to the equities market right now doesn’t appear to be weakening earnings. The biggest risks are the actions (or a lack thereof) of the Federal Reserve and the European Central Bank. Perhaps in the fourth quarter or even next year, the equities market won’t be able to escape corporate fundamentals, but right now, confidence in financial markets is the catalyst.
With a little more reassurance from central banks, I feel that this stock market will move higher, solely based on improved investor sentiment, not fundamentals. Second-quarter earnings season was the first real evidence of declining economic growth in the eurozone and emerging markets affecting U.S. corporate earnings. It’s likely that the third quarter will be worse.
The equities market has a way, however, of excluding current reality if there’s hope for the future. This is the kind of stock market we have presently. It continues to be a wacky year for the stock market; anything is possible over the next two quarters.