The year 2014 was the third to see a stock-market rally, but unlike the period 2012 through 2013 when expanding price-to-earnings (P/E) ratios drove a large part of returns, this year's gain was mainly driven by earnings growth.
This reflects the fact that optimism is becoming more contained and the market is moving in line with economic fundamentals. The contained optimism provides an easier start for the market in 2015 as stock prices do not need to climb the wall of high expectations. But will 2015 be another winning year for stocks? I think it will.
First, the current three-year rally does not look excessive by historical standards. Take the S&P500 for an example: The index went up by almost 65 per cent in the past three years, but the gain is relatively small when compared with the 220-per-cent rally between 1995 and 1999.
Second, liquidity will remain ample as the European Central Bank and Bank of Japan continue to ease. The BOJ decided in October to accelerate purchases of Japanese government bonds in 2015 so that its holdings increase at an annual pace of 80 trillion yen (Bt22 billion), up by 30 trillion yen from 2014. ECB president Mario Draghi also pledged to boost the bank’s balance sheet back towards 3 trillion euros to stem the risk of deflation in the euro zone.
According to a Bloomberg survey, economists expect the ECB to expand its balance sheet by about 550 billion euros (Bt22.4 trillion) by the end of next year.
The additional liquidity provided by the ECB and BOJ in 2015 will more than offset the US$454 billion (Bt14.9 trillion) provided by the US Federal Reserve in 2014.
In terms of valuation, equities still look more attractive than bonds. The current stock-market P/E ratio is consistent with a mid-cycle recovery but bond yields are still near record lows. This means that the stock market is to a certain extent trading in line with the economic cycle, but bonds look very expensive.
But the biggest obstacle to the rally next year is the prospect of the Fed raising its benchmark interest rate.
Market consensus expects the Fed to raise the rate around mid-year. As the most important benchmark for global interest rates, a hike in the Fed funds rate will increase discount rates for all financial assets, which will in turn exert negative pressure on valuations.
In the past three rate-hike cycles, the P/E ratios of the S&P500 contracted by 8.6 per cent on average in six months after the first rate increase. However, strong earnings growth usually offsets P/E contractions, leaving positive returns for the index.
This rate hike is quite special as it comes later in the recovery cycle, hence first, P/E is much lower (26 per cent lower than the average of the past three rate increases), and second, earnings growth is much lower because earnings had already normalised. I expect P/E contraction to be mild this time and the market to go up in 2015 as relative valuation and liquidity still support equities investment and low inflation will allow the Fed to pursue a less aggressive rate increase.
Nevertheless, an increase in the Fed funds rate will be the most important risk event in 2015. Investors should prepare for increased volatility as the rate hike nears.
Komsorn Prakobphol is head of the strategy unit at Tisco Wealth. He can be reached via www.tiscowealth.com or email@example.com.