Tapering - What Will Happen?

Let’s assume for a moment the Federal Reserve starts to taper and the economy does just fine.  Economic data remains decent and GDP continues to grow at a modest pace.  What will the Fed do if the economy can handle "less Fed intervention"?  The assumption is the Fed will decide to taper more quickly.  If it is determined that tapering doesn't hurt the economy, expect the Fed to taper at a faster rate, which given the current environment will likely hurt stocks more than bonds. Volatility will likely increase.

 

Now let's assume the Federal Reserve starts to taper and it impacts the economy.  Economic data starts to show a decline in activity and GDP growth slows markedly.  Will the Fed stop tapering and start buying again? Very likely.  But the market may not assume this outcome and may decline.  In this crazy, upside down world the Fed has created, it's very possible that the Fed will taper, economic data gets worse, the Fed "un-tapers", starts purchasing again, and markets rally as they realize the Fed and QE is here to stay.  Volatility will likely increase in this scenario as well. 

 

Based on these assumptions we can likely conclude that volatility in the markets (both stock and bond) is likely to be around over the next few months regardless of what the Fed ultimately decides to do.

S&P 500 Earnings Estimate Update

Due in part to negative EPS guidance, analysts have lowered earnings expectations for the third quarter. The estimated earnings growth rate for Q3 2013 is 4.8%, down from an estimate of 6.9% at the start of the quarter (June 30). Seven of the ten sectors have recorded a decline in expected earnings during this time, led by the Materials and Information Technology sectors.

The Materials sector has seen the largest drop in expected earnings growth (to 1.1% from 15.3%) since the start of the quarter. Companies in the Metals & Mining industry have witnessed the largest cuts to estimates during this time.  The Information Technology sector has witnessed the second largest decrease in expected earnings growth (to 1.8% from 5.5%) since June 30.

Although analysts have reduced earnings growth expectations for Q3 2013 (to 4.8% from 6.9%) and Q4 2013 (to 11.1% from 12.1%) since June 30, they still expect a significant improvement in earnings growth in the second half of 2013 relative to the 1st half of 2013.  For Q3 2013, two of the ten sectors are projected to see double-digit earnings growth: Financials (11.7%) and Consumer Discretionary (10.0%).

However, estimated revenue growth rates for both Q3 2013 (2.8%) and Q4 2013 (0.7%) are expected to be below estimated earnings growth rates, particularly for Q4 2013. No sector is expected to see double-digit revenue growth in either quarter.

Interestingly enough, earnings estimates for 2013 continue to decline (as they have all year).  Current expectations are for $108.50 for fiscal 2013 as of July 31st, down from roughly $112.00 in January, and down from roughly $110.50 at the end of April.  It is highly unlikely markets can continue to rise if earnings estimates continue to decline.