March 19th, 2013 | By Nick Sargen
What's Behind the Stock Market Surge?
One of the most noteworthy developments this year has been the strong surge in the U.S. stock market, which has sent the Dow Jones Industrial Average to new highs and the S&P 500 to a near-record high. Previously, we thought the market could test its former highs this year, but we did not expect it to happen this quickly, considering that news on the U.S. and global economy has been mixed.
This begs the question of why it is so strong. The most commonly cited explanation is that the Fed's policy of quantitative easing has created incentives for investors to acquire equities and other risk assets. Nonetheless, while this is part of the story, it is not the full story.
The other major force at play is that the private sector of the economy – consisting of households, businesses and financial institutions – is performing better than the overall economy. Real GDP growth, for example, has averaged about 2% per annum since recovery began in mid-2009, while the private sector has been growing at about a 3% rate in the past two years. Should this pace be maintained the economy is capable of sustaining overall growth of 2% even in the face of so-called "fiscal drag."
Following is some of evidence that supports the view the economy is gaining traction:
Compared to the private sector, there are still large imbalances in the government sector, owing to a ramp-up in spending during the financial crisis as well as increased transfer payments. During the past two years, however, growth in government spending has slowed considerably, and federal spending is projected to be little changed this year with sequestration in effect. Along with the 2% increase in payroll taxes and the hike in tax rates for the wealthy, the federal budget deficit is projected to decline to about 5% of GDP in 2013, or roughly one half the magnitude during the financial crisis.
To be sure, this does not mean the economy is firing on all cylinders. The key to a sustained expansion is a pick-up in consumer spending, which accounts for nearly 70% of aggregate demand. Thus far, personal consumption has been expanding at only a 2% pace, which is too slow to boost the overall growth rate when government spending is being pared back.
A key test for the markets is how consumer spending will hold up when the full effects of the increase in payroll taxes and the implementation of sequestration are felt. During the first two months of this year, consumers responded by drawing down on savings to maintain their spending pace. However, this cannot continue indefinitely. One possibility, therefore, is that consumer spending may slow in the next two quarters. If so, it may cause investors to reassess the economy's prospects and could set the stage for a long-awaited pullback in the stock market.
In that event, however, we believe there are powerful offsets that will sustain the economy and eventually cause it to re-accelerate. They include stronger jobs growth, which will boost disposable income, and improved household net worth, which will help sustain consumer confidence. At the same time, we believe financial institutions will be more willing to extend credit to households and businesses, which should support the expansion. Therefore, we believe any slowdown in consumer spending will prove to be temporary.
At the beginning of this year, we believed the stock market could test its all-time highs based on our belief the economy was gaining traction. The main surprise for us has been how strong the market has been thus far, when news on the global economy has been mixed. While this could leave the market vulnerable to a pullback, especially if consumer spending were to slow, we are growing more confident that the private sector is gaining traction. If so, the stock market is likely to advance further in the second half of this year. Therefore, we are maintaining an overweight position in favor of U.S. equities in balanced portfolios.