Weighing The Week Ahead: What Is The Risk And Reward For Stocks?

With stocks hitting new highs and the bull market reaching age five, the potential for a market top is a popular subject. There is a light schedule of economic releases, so pundits will be free to spend nearly full time explaining the rally and offering their forecasts.

Expect even more articles like “Six reasons this is a market top” and “How to protect your portfolio.”

I could get more page views with a title like that, but let us try to put this more neutrally and make it forecast-free:

What is the risk/reward for stocks?

Last Week’s Theme Recap

I expected last week’s theme to be focused on employment and that was mostly correct. I also noted that there would be continuing attention on the Ukraine situation, with events changing rapidly. The market was reacting to the potential for armed conflict. I provided several balanced sources to help your assessment of events, concluding as follows:

If you are too lazy to read these brief and helpful articles, here is the one-sentence summary: We are very distant from a US/Russia armed conflict. There are umpteen diplomatic steps along the way, starting with skipping a planned trip to Sochi.

This is a perfect illustration of the reason for my weekly post – planning for the week ahead. Readers are invited to play along with the “theme forecast.” I spend a lot of time on it each week. It helps to prepare your game plan for the week ahead, and it is not as easy as you might think.

This Week’s Theme

How should we evaluate the overall market risk and reward? There are three basic positions:

1. Skeptics and top-callers. Stocks are over-valued, supported only by the Fed. Compare to what happened when stocks visited these levels before. The cycle is extended and overdue for a correction.This article is typical of many.
2. Reasonable valuation. Modest growth has supported the market ascent. Stocks are fairly priced and can continue single-digit growth if sales and earnings keep pace. Josh Brown cites distinctions between now and 2007.
3. Bullish prospects. The economic cycle has not yet reached trend levels. A rebound in economic growth could spark a strong second half to 2014. Some even worry about a melt-up, with both increased earnings and multiples.

No one can make a confident forecast for the next market move, but it may be possible to define some limits. I have some thoughts that I will share in the conclusion. First, let us do our regular update of the last week’s news and data. Readers, especially those new to this series, will benefit from reading thebackground information.

Last Week’s Data

Each week I break down events into good and bad. Often there is “ugly” and on rare occasion something really good. My working definition of “good” has two components:

1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially — no politics.
2. It is better than expectations.

The Good

There was plenty of good news.

• Eurozone PMIs are improving. Hale Stewart reports on the Markit index at 53.0 and above the earlier flash estimate. I am still cautious about the interpretation of these reports. I suspect that a sharp journalist will soon make a deep dive into the methodology. There is definitely a market impact, reflected in overnight futures. We care about Europe, but is this the best measure. (Same question for China).
• Bullish sentiment (a contrarian indicator) is still low. Our favorite chart of this via Bespoke:

• ISM manufacturing beat expectations, signaling expansion with a reading of 53.2. Steven Hansen at GEI has a comprehensive analysis. Read his full story for charts, comparisons with regional Fed surveys, and discussion of the component categories. It is a comprehensive look at an important report.
• The PCE price index is up only 1.18% year-over-year. This is the measure of inflation watched by the Fed, with a target of 2% and a willingness for a temporary increase at a higher level. If you want to profit through understanding the Fed, you had better start with following the PCE. Doug Short has the analysis and charts we have grown to expect, including this one:

• Americans are richer than ever. US household assets increased by $9.8 trillion or 14%. Scott Grannis has the story and also several charts. This one shows that we are almost back to trend growth:

• Four million properties returned to positive equity in 2013. CoreLogic data via Calculated Risk.
• The Fed’s Beige Book shows modest growth. Calculated Risk has a great analysis, noting the regional differentials and weather effects. Scott Grannis explains why modest growth has been working just fine for stocks. (Chart lovers should check this out).
• Personal spending increased 0.4%, beating expectations.

• Employment growth was mixed, but generally a market positive. It was better than expected on several fronts

  • Payroll growth showed 175K net gain in jobs.
  • Labor force participation increased.
  • Higher unemployment rate is probably a more accurate reflection of reality and gives the Fed a little room to remain aggressive.
  • State governments are no longer a source of job losses. (WSJ analysis and charts).
  • Initial jobless claims declined 26K, back to the bottom of the range.

  Matt Phillips at Quartz has a great chart package. Here are two of special interest, showing weather effects and the decline in involuntary part-time employment (still a problem, but much better).