July 28 (Bloomberg) -- No one expects a meteorologist to accurately forecast the weather on New Year’s Eve a full 12 months in advance, yet Wall Street has no problem making such demands of its big-name market strategists.
So when Gina Martin Adams of Wells Fargo & Co. put an 1,850 forecast on the Standard & Poor’s 500 Index in January, it was one thing. At that time the prediction called for a flat market for 2014: Not the best year to hit the beach, but also no reason to rush to the store to load up on milk and eggs.
Holding firm to that estimate after this year’s rally in stocks is something else. Now the projection, which is tied with Deutsche Bank AG and Stifel Financial Corp. for the lowest among 19 estimates tracked by Bloomberg, needs a 6.5 percent drop in the S&P 500 from last week’s close to come true.
So what is it about the market that makes Adams comfortable sitting on the bottom rung of the strategists’ table, even after lingering in that spot proved to be a bad idea last year? Interest rates are the main concern, she said in a telephone interview today, as history suggests risk tolerance and equity valuations come under pressure when the Federal Reserve tightens policy.
Among the many potential impacts higher rates can have on the economy and markets, she focused on profit margins today. Lower borrowing costs have contributed 60 basis points, or 0.6 percentage point, to net margin expansion over the past five years for non-financial companies in the S&P 500, according to Martin Adams. As a result, net margins have been at record levels over the last three quarters even as margins before interest, taxes, depreciation and amortization have fallen.
The decline in non-financial EBITDA margins is “sending something of an ominous signal” that may be followed by a peak in net-income margins, she wrote in today’s report. “Peak margins were a good indicator of impending recession in each of the last cycles,” she wrote. Sales growth will have to pick up considerably in order to ease concern about margins, she said.
Martin Adams proved to be too pessimistic last year.
The Wells Fargo strategist’s year-end forecast was 1,390 at the beginning of 2013, the lowest among 15 estimates tracked by Bloomberg at the time. The average estimate was 10 percent above hers and the index finished the year 33 percent above her projection. Her January estimate of 1,360 for the end of 2012 was more accurate. It was 1.2 percent above the mean and the market ended about 4.9 percent higher than the projection.
The Fed’s unprecedented efforts to stimulate the economy by keeping interest rates near zero for more than five years haven’t made reading the Wall Street weather maps any easier.
“It makes forecasting somewhat difficult,” Martin Adams said today. “Historical relationships don’t play out as you would expect.”
Each period of history has its own unique challenges. The current one’s challenges may be unique for how unique they are.
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