6 Reasons the Stock Market Could Do Surprisingly Well in 2013

A slow-growing economy with little inflation can actually be the best environment for blue-chip stocks.

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The S&P 500 hit a five-year high last week, and now some experts are saying that stocks are overpriced and that the overall market is vulnerable to a 20% drop this year. There are certainly plenty of things to worry about, from a lousy economy and political gridlock in Washington to the possibility of a financial crisis in the euro zone. But there’s an equally compelling case that stocks could do quite well in 2013. Indeed, it wouldn’t be hard for the Dow to sail through its all-time high of 14,164 and go on to top 15,000 before the year is out – a gain of 10% or more from current levels.

There’s no denying the economy’s current problems. Since the recession ended more than three years ago, growth has been consistently disappointing for a recovery. Moreover, the economy has actually been slowing down recently – from a 3.1% annualized growth rate in last year’s third quarter to less than 1.5% in the fourth quarter. In addition, analysts project that the fiscal cliff deal, combined with attempts to cut the deficit, will knock as much as a full percentage point off GDP growth in 2013. In short, this year’s economy figures to be just as sluggish as last year’s – and maybe worse.

But the pessimists’ case for a bear market is based on more than a limping U.S. economy. They think the bull market – up more than 100% over the past three-and-a-half years – has run its course. They expect a global slowdown that will cause 2013 corporate profits to fall short of expectations. Finally, they think the Federal Reserve’s extreme easy-money policies will either lead to inflation, or that the Fed will have to raise interest rates. Either way, it would send the prices of Treasury bonds into a tailspin and unsettle the stock market as well.

Whew! That’s a lot to worry about. But today’s bearish commentators are making one crucial incorrect assumption – that share prices move in lockstep with the economy. It’s true that over the long term, share prices follow corporate profits and that corporate profits reflect the economy. But that relationship doesn’t necessarily hold in the short run. Here are six reasons to question the gloomy outlook:

1) Trends in corporate profits can diverge from the economy as a whole. Sluggish GDP growth tends to keep costs down, especially labor costs. So even with only moderate sales, companies can enjoy rapidly expanding corporate profits. And that’s exactly what has happened since the recession ended.

2) The level of inflation can count for more than changes in corporate profit growth. The level of stock prices is normally gauged by comparing them with company earnings. When inflation is above 3% a year, these price/earnings ratios tend to be subpar. Deflation – consumer prices that are actually falling – isn’t good for stocks either. But inflation of 1% to 2% can support P/E ratios that are one and a half times normal. Over the past 12 months, inflation has averaged a nearly perfect 1.7%.
3) The Fed’s easy-money policy can go on for some time. Quantitative easing – the modern-day equivalent of printing money – can be maintained until the economy speeds up enough for all the extra cash in circulation to translate into inflation. As long as there is minimal inflation, the Fed can continue its easy money policy, which keeps interest rates low and supports stock prices that are higher than normal. Indeed, today’s rock-bottom rates could theoretically justify P/Es in the 40s – or almost double today’s levels. As long as current conditions continue, the Dow should be able to keep moving higher.

4) Flows of funds are likely to be positive for stocks. Any cash that flees a falling Treasury bond market or a euro zone crisis will be looking for a safe haven – and U.S. stocks will offer a prime shelter. In addition, corporate cash holdings have reached a record high ($1.73 trillion as of Sept. 30), because companies don’t need to reinvest much in an economy that is growing very slowly. That cash will be available to raise dividends, buy back shares or acquire the stock of takeover targets.
5) Stock prices are by many measures still quite moderate. If you compare current prices to estimated 2013 operating earnings (i.e., without nonrecurring items), the P/Es of blue chips have risen by about 30% from their 2008 lows, but are a similar distance below their highs at the 2007 market peak. By some other measures, prices are a bit above average. But they certainly aren’t insanely overvalued.

6) The long-term outlook is getting better rather than getting worse. Since share prices already reflect most of what’s known about the economy, the key question is how conditions are likely to develop in the future. The economy is continuing to grow, however weakly. Unemployment has been coming down consistently, if painfully slowly. And home prices seem to have hit bottom and turned up a little bit.

Ultimately, in other words — and as perverse as it may sound — a mildly disappointing economy can be quite good for stocks. High unemployment keeps labor costs low and corporate profits fat. Low potential returns elsewhere could encourage money to flow into U.S. stocks. As long as there’s no recession, no really terrible crisis overseas, and no pickup in inflation, stock prices could continue to move up – at least for another year or two. Unless stocks get to levels where they are clearly overvalued – 17,000 or 18,000 on the Dow – it makes sense for most investors to stick with their long-term portfolio strategies and not try to outguess the market.