Blog : Janet Yellen's Stock Market Outlook

by Ed Zwirn on June 19th, 2014

As we near the end of Q2, we find the stock market in a state similar to that which prevailed about one year ago. Having repeatedly hit and retreated from new highs, the major stock market indices all found themselves marginally ahead in Q2, with the Dow Jones Industrial Average up around 2.7% from March 31.

This represents a slowdown from the faster (2.9%) gain seen in Q2 2013, with the slackening pace indicative of both slower U.S. economic growth and the fact that the bull market is aging and so needs more stellar performance to meet or exceed past gains. But, whatever drove its performance last time around, the market languished for much of the rest of last year, with the Dow gaining 1.7% in a rocky Q3, plagued by everything from international developments to threats (later realized) of a government shutdown and sequestration budget cuts.

Now, according to no less an authority than Janet Yellen, chair of the U.S. Federal Reserve, warns that we may be witnessing similar market vulnerabilities.

Yellen's argument hinges on the fact that stock market volatility has declined and turns this apparently positive trend on its head. "Volatility, both real and expected, is at low levels," she said in response to a question at the press conference held Wednesday afternoon as a followup to that morning's Fed policy statement announcement.

This low level of volatility, she pointed out, has had the effect of increasing risk appetite as investors seeking yield migrate to investments likely to produce greater returns. As can be seen by the Q2 performance of the Dow, this migration has benefited equities broadly, since stocks offer better returns than other "safe" options like Treasury debt and investment grade bonds. In addition, smaller stocks, including penny stocks, have participated in this upturn, with the small-cap Russell 2000 also up 2.7%, to keep up with the 30 large-cap Dow stocks.

The problem, as Yellen points out, is that this recently induced risk-taking behavior is extending to all sorts of investment likely to spur vulnerability over the longer term. Penny stocks, which are fairly high up the risk ladder, of course carry with them their own vulnerabilities. Being by definition smaller companies, they are as vulnerable to company-specific news developments as they are to macroeconomic trends and market swings.

But beyond penny stocks, the current lower market volatility is boosting other kinds of risky behavior which may pose greater threats to stock market valuations over the longer haul. The market remains vulnerable, according to Yellen, "to the extent that low levels of volatility may make risk-taking behavior more common." This is a concern for the Fed, she says, particularly if this behavior involves taking on increased leverage.

And this leverage, which can be viewed as destabilizing in-and-of-itself, has also served to heighten the sensitivity about interest rates going forward. Although the "central tendency" of the latest Fed governor survey envisions low interest rates continuing through at least the end of 2016, Yellen points out that these survey responses included a wide rage of forecasts and assumptions. "It is important for market participants to recognize that there is uncertainty as to the path of interest rates," she emphasized.

And while we're talking about central tendencies, the Fed governors, as a whole, expect only a gradual return to higher interest rates and slow progress on the labor front. Inflation, which is the most frequently stated yardstick by which the Fed says it will adjust monetary policy, is expected to move "only gradually back" up toward the target of 2%, hitting 1.5% to 1.7% this year and rising to 1.6% to 2% in 2016.

And while the unemployment rate, supported by large job-growth figures, is, at 6.3%, a whopping 0.4% lower than that registered as of the last Fed announcement in March, Yellen realistically says that progress like this will tend to level off in the face of continued "secular decline in the labor participation rate." As I pointed out in this investment blog earlier this month, at least some of this decline is due to "demographic effects," Yellen notes.

But, beyond demographics, as Yellen pointed out, there are a great many who have backed out of the labor force out of discouragement about the economy and the chances they may have of actually landing a job. As the "good news" about the economy continues to pile up (and assuming it does), there is a chance that these discouraged may cheer up and hit the pavement again. This would have the effect, all else being equal, of driving up the unemployment rate, or at least slowing its decline.

The upshot for investors: While there has been reason for cheer about the economy, the stock market remains at high levels and is therefore vulnerable to downside risks, particularly as uncertainty over interest rates continues to spook a leveraged investor community. On the other hand, keeping the Fed's longer-term outlook in mind, continued low inflation and labor market weakness should keep short-term interest rates low at least through the end of 2016, and that's as much certainty as we can allow ourselves at this juncture.