By the time this is piece is published we will be 24 hours from the time the polling booths will open. The bookmakers, the pollsters and the capital markets still seem to favour a Conservative victory. The odds of the 100-seat majority forecast a few weeks ago have widened. One factor that may have been overlooked that may influence the outcome, the Sun newspaper. Ever since the famous headline” would the last person to leave the country please switch off the lights” that did for Mr Kinnock so many years ago to give John Major an unexpected victory. The Sun newspaper has seemed to hold sway on the voting public. There are greater brains than ours at the Sun working on Thursday mornings headline, whichever way it falls it's likely to once again influence public opinion.
In the meantime, the other question mark remains what the Federal Reserve will do with interest rates. The odds remain in favour of a raise at next week’s meeting. Monday’s economic data was inconclusive, factory orders fell 0.2% month over month in April. The first drop in new orders since November last year. The Markit composite purchasing manager survey came in at 53.6, above last month but slightly below expectations. Likewise, the Institute for Supply Management’s services PMI came in slightly below expectations, however at 56.9 remains well into expansionary territory. None of this data is probably enough to put the Fed from their current chosen path.
The Federal Reserve expect economic growth in the second quarter to be stronger than the first, the bond market may be telling a different story as the US Treasury yield curve has flattened from the start of the year. The gap between two-year and ten-year interest rates was 1.25% at the start of the year, it currently stands at 82 basis points. A flattening yield curve traditionally suggests the bond investors are less optimistic about the outlook for growth. The bond market continues to signal to investors one thing the equity market seems to focus on another.
Merrill Lynch believes the bond market is wrong, however, if it is not and the outlook for the US economy does weaken in the following year, the 10% earnings growth analysts now forecast will fade and equities will correct by 13-20 %, in their view. Much is made of the elevated valuation the US market is currently on relative to history, circa 18x against historic nearer 15x. Higher multiples in stocks and markets are fine when earnings are rising as the asset can grow into the valuation. The problem comes when disappointment comes as you get a valuation de-rating alongside a earnings revision. A double whammy.
According to Factset Research, the forecast EPS for the S&P 500 is $140 per share. Multiple that by 18 and you get close to the current market value of the S&P 500. If you take the EPS back by for example to $130 a share on the current multiple the market would correct about the 10% as Merill Lynch suggest. Should the market de-rate back to historic valuations a correction of nearer 30% could be possible.