Four Reasons Why U.S. Stocks Have Already Peaked for 2013

I made a prediction on July 24 that the U.S. stock market was poised to fall.

Since then, the Dow Jones Industrial Average and the S&P 500 Index are down about 3 percent (as of yesterday morning), even after hitting record highs in early August.

At the time, I warned that for most of 2013, investors had been in a buying mood as Federal Reserve Chairman Ben Bernanke consistently reaffirmed easy-money policies. But as I cautioned, those policies — official interest rates near zero and trillions of dollars in bond buying — can’t go on forever.

Based on recent developments, I have become convinced that early August marked the top of the equity markets for 2013 — the S&P 500 at 1,710.

That’s because P/E multiple expansion, not earnings growth, has fueled the rally in U.S. equities. (That term refers to a situation in which the price-to-earnings, or P/E, ratio rises because investors are increasingly willing to pay more for a dollar of earnings.) In fact, Scott Minerd of Guggenheim Partners reports that while the S&P 500 has increased by more than 34 percent since the beginning of 2011, only 6 percent of that return has come from earnings growth, and the rest from multiple expansion.

Recall that there are only three elements of investment return: P/E multiple change (expansion or contraction), earnings growth and dividend yield, with P/E multiple change being the most volatile and unpredictable factor.

A rally in stocks driven by multiple expansion, not earnings growth, is likely unsustainable and a market decline seems inevitable.

More alarming is the fact that corporate earnings growth has slowed (instead of accelerated) during that same period, registering the slowest earnings growth in non-recession years since 1998. Without renewed earnings growth, a rally in stocks driven by multiple expansion is likely unsustainable and a market decline seems inevitable.

It’s also interesting to note that this expansion in P/E multiples over the past 2 1/2 years has occurred despite these factors: Questions about the sustainability of growth in China, mounting evidence suggesting that further quantitative easing may be ineffective, a growing lack of confidence in our leaders in Washington D.C., and disappointing revenue and profits in the second quarter.

That means the S&P 500, despite its recent decline, still stands within 4 percentage points of an all-time high because investors have discounted all of this bad news and looked toward the future with optimism.

But I see evidence that this upward trend in the stock market will come to an end.

Below are four reasons why I believe the U.S. stock market has peaked for the year. For space considerations, I will list three more next week. Please let me know what you think on Money and Markets’ Facebook page.

1. The selection of a new Federal Reserve chairman is a bigger deal than is expected. Whether the ultimate choice is Larry Summers, Donald Kohn, Janet Yellen or perhaps even Tim Geithner, the selection process is going to be bumpy. And a market that is being held together by an easy-money policy can’t take a lot of uncertainty.

2. Politics will move to the forefront in the coming months. The September-October political agenda includes: Raising the debt ceiling, more government spending, a new immigration policy and tax reform. A drawn-out fight or impasse on any of these matters would undermine consumer and corporate confidence.

3. The expected 2013 tapering is likely a policy mistake. I anticipate that the Fed will reduce its bond buying this month despite the fact that the economy is still growing at a subpar pace. The central bank’s four-year-plus strategy of quantitative easing is getting increasingly ineffective — it has neither created jobs nor stimulated innovation.

While I recognize that tapering lies ahead, tightening does not. But it’s my view that the rise in long-term yields over the past several months was accelerated by the Federal Reserve’s announcement that it would soon be lowering its purchase of Treasury and mortgage-backed securities. That has caused a dislocation in the bond market since mid-June, producing losses for many fixed-income investors.

4. Economic fragility. The recent data indicate that the economy is growing slowly, characterized by job growth that is weak in quality, retail sales that are stalling, and car sales that have flat-lined.

In my Aug. 21 Money and Markets column, I explained that consumers haven’t healed from the Great Recession because incomes haven’t risen and jobs have been hard to come by. That means, based on the standard of living in the U.S. (as measured by real median household income), the so-called recovery has entirely bypassed the consumer sector.

Best wishes,

Bill

Bill Hall is the editor of the Safe Money Report. He is a Certified Public Accountant (CPA), Chartered Financial Analyst (CFA) and Certified Financial Planner (CFP). Besides his editorial duties with Weiss Research, Bill is the managing director of Plimsoll Mark Capital, a firm that provides financial, tax and investment advice to wealthy families all over the world.