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There is an elevated level of investor sentiment at the moment which could presage a pullback in stocks, although the fundamental outlook for U.S. stocks and the U.S. economy continues to improve. At the very least, we are likely to experience lower returns in the second half of 2014 than in the first. According to several market sentiment indicators, investors are undergoing “extreme” optimism. In fact, most of these indicators are at or near their highest historical levels of bullishness. Combined with historically low levels of volatility, the market seems vulnerable to any bad news.

Yet it is difficult to build a case for selling. Although GDP growth in the first quarter was revised down sharply to -2.9%, this has been largely brushed off by economists, explained by the severe winter weather. Investors now expect an important rebound when Q2 GDP numbers are released in July. Consumer confidence, still climbing, is far from its historic highs. U.S. unemployment has fallen to 6.3% from 6.7% at the end of the first quarter. Vehicle sales are hitting their highest selling pace for the year. Economic activity in the manufacturing sector expanded in May for the 12th consecutive month, and the overall economy grew for the 60th consecutive month. Leading indicators of capital spending in the U.S., the U.K. and the euro zone are near their historic highs, suggesting that business capital expenditures may continue to surge in the coming year. American companies have never been more profitable than they are today, with corporate profits as a share of GDP at record highs. Housing data is improving, with new home sales up over 18% vs. last year. American households remain under-invested in stocks compared with historical levels, and stock valuations are at only “average” levels.

Corporate stock buybacks continue to support the market and will continue to do so as long as interest rates remain low. This is because companies have an incentive right now to borrow at very low rates and then use the proceeds to buy back their own shares, which increases their earnings per share. If rates begin rising, this process will reverse. Interestingly, certain measures of inflation, like the Personal Consumption Expenditure (PCE) index, rose in Q2 to its highest rate in 12 months, climbing to 1.8%. While this may seem low, it’s worth watching this indicator to gauge whether the trend continues. An excerpt from the Federal Reserve’s most recent FOMC meeting merits consideration:

…..the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored….

In short, it is still unlikely that the Federal Reserve begins to raise interest rates just yet. Even if the perception over the timing of such a move were to occur, the start of an interest rate hiking cycle has never stopped a bull market; it is historically toward the end of a hiking cycle that the risks of a bear market increase.

There is certainly no lack of risks in the world today that might cause a pullback. Turmoil n the Middle East first comes to mind when considering the potential impact on oil prices, especially given the intractable nature of the Syrian and Iraq conflict. Yet U.S. oil output is at a 28 year high, which has dampened the impact of the Iraq crisis on the oil market. An increase in U.S. oil production of 2 million barrels per day has largely offset the disruption n oil production from Iraq, Iran, and Libya. The good news is that drilling expansion will continue to boost American energy independence. For this reason, the U.S. onshore energy sector should continue to perform well for years to come.

If a sudden change in investor sentiment does provoke a pullback, it is likely to be a buying opportunity, and a temporary one.

For the first half of 2013, The Dow was up 1.5%, the S&P 500 was up 6.1%; and the Nasdaq was up 5.5%.

Grant Rogers

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