Because we invest in individual companies, we seldom make formal forecasts regarding short-term market performance or year-end index targets. Nonetheless, we are frequently asked what we anticipate from markets in the weeks and months ahead. At the start of the year, we outlined a scenario in which the S&P 500 might return 8-9% in 2014, based on a constant P/E, 6% earnings growth, and 2% from dividends. At mid-year, the S&P had returned 7% thanks to a strong second quarter for stocks (up 5%).

Equity investors continued buying stocks in the first half despite government data showing the economy shrank by an annualized 2.9% in the first quarter. This contraction was so inconsistent with underlying trends that it was widely dismissed as an outlier rather than the start of a new cycle. We continue to agree with this assessment: none of the other data corroborate an about-face from 2.6% growth in Q4 to a near 3% decline in activity. The harsh and prolonged winter bears some blame for the anomalous reading. Another factor that reduced output was less spending on healthcare as changes related to The Affordable Care Act took effect.

Economic growth (or lack thereof) has profound implications for corporate profits, so if market participants had viewed the apparent Q1 contraction as anything more than a one-off, stocks would have been reasonably expected to retreat from new all-time highs. Perhaps the more important driver for stocks in the short-term is the Federal Reserve and the perceived timing for tapering Quantitative Easing (QE) programs. We’ve long argued that because QE did not dramatically help the economy, ending it is unlikely to stifle the economy or hamper businesses. However, perception is often reality for stocks in the short run. Following former Fed chairman Bernanke’s awkwardly timed statement a year ago in June about tapering, stories and rumors that hinted at changes in the Fed’s exit strategy disproportionately whipsawed markets. This led to the strange dynamic in which bad economic news was well received by equity markets because it lessened the likelihood that the Fed would exit sooner. And surprisingly strong data had the effect of driving stocks down because of the fear that the Fed would continue the process of normalizing rates.

We continue to believe stock prices are well-supported at these levels by strong fundamentals: record high profits, growing earnings per share, free cash flow, and effective uses of capital (e.g. strategic M&A). Peloton is also in the camp that sees a quick return to modest GDP growth in Q2 and a broadening expansion through 2014. This would allow the Fed to keep on tapering – gradually scaling back its monthly QE activities (buying fewer Treasury bonds and mortgage-backed securities). Eventually, short rates will rise and the entire yield curve will move more towards pre-crisis levels.