Time Of Year For A Routine Financial Check-Up

OCEAN CITY — The final days of summer provide an opportune time to check the health of the U.S. stock market. U.S. equities pulled back by 4% from recent highs and the 10-year Treasury yield fell to the lowest level in more than a year in a typical flight to quality move.

To get a handle on what might be next for stocks, it’s useful to examine a range of factors — fundamental, macroeconomic and technical. We think that for the next 12 to 18 months, fundamentals and technicals remain supportive for U.S. stocks, while the macro environment is mixed.

Our fundamental lens reveals a positive outlook for equities. Corporate earnings have been reasonably strong, profit margins have held up and companies are still generating healthy levels of cash flows.

Corporate earnings have helped the market power through the challenges of this year’s unanticipated geopolitical turmoil. With more than 90% of the S&P 500 having reported for the second quarter (as of Aug. 8), earnings per share (EPS) is on track to grow approximately 10% year-over-year (YoY), according to BofAML Equity & Quant Strategist Savita Subramanian.

Our macro lens presents a mixed picture of an improving economy but with significant uncertainty with respect to Federal Reserve (Fed) monetary policy and interest rates as well as geopolitical tensions.

We see signs of a better economy after the disappointing start to the year, when U.S. gross domestic product (GDP) unexpectedly contracted and China’s growth slowed. In the U.S., we have been encouraged by recent manufacturing and jobs data. The manufacturing index of the Institute of Supply Management (ISM) rose to 57.1 in July from 55.3 in June. This was better than expected and the highest level since April 2011, with 17 of 18 industries reporting growth. Similarly, July payrolls rose by 209,000, indicating a steadily improving jobs picture.

Payrolls have now increased by more than 200,000 for each of the last six months, a sign that Main Street is finally benefiting from the recovery. BofAML Economist Ethan Harris expects the U.S. economy to grow more than 3% in the second half of the year and by 3.2% in 2015.

On the flip side, equities will continue to receive cues from how the Fed manages the process of ending its quantitative easing program in October and eases investors into the idea of raising the policy rate. It is natural for investors to be nervous about what happens to asset prices as the era of abundant central bank liquidity and zero rates comes to an end. The Fed’s actions will remain dependent on the economy, but with inflation still not a concern — another positive on our score card — we think its policy should remain accommodative. Our economics team predicts that Fed Chair Janet Yellen and company will start talking about rate hikes in the spring and start raising rates in the second half of 2015.

As we wrote in last week’s Weekly Letter, “Approaching an Inflection Point,” this process is likely to bring volatility to the interest rate market with likely spillover into equities. Similarly, rising geopolitical tensions have the potential to ignite risk aversion. With ongoing conflicts in Iraq, Ukraine and the Middle East, global turmoil seems to be more widespread than it’s been in years.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)