Why a surging U.S. economy won't fuel a late-year stocks rally

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The U.S. economy has given the naysayers a lot to think about with this week's batch of good news. But can you expect it to drive a stock market rally?

The evidence of better-than-expected economic activity comes as a big relief to anyone fretting over whether the United States can possibly succeed when the rest of the world is struggling.

So far, the evidence suggests it can. Gross domestic product rose by 3.5 per cent in the third quarter, at an annualized pace. That topped expectations for growth of 3 per cent – and it follows an impressive reading of 4.6-per-cent growth in the previous quarter.

"Growth above 3 per cent in four of the past five quarters is starting to look like a trend," said Ian Shepherdson, chief economist at Pantheon Macroeconomics, in a note.

This wasn't an outlier, either. Weekly jobless claims remain low, signalling monthly employment gains ahead and a further decline in the unemployment rate. Home sales are holding up and consumer confidence, as measured by the Conference Board, has surged to a seven-year high.

The Federal Reserve is sounding upbeat. On Wednesday, it announced the end of its bond-buying stimulus program, known as QE3, pointing to solid job gains, rising household spending, advancing business investment and a lower likelihood that inflation will get stuck below its 2-per-cent target.

Add it up and there's enough evidence here to kill lingering skepticism over the U.S. economic recovery and build a case for a late-year stock market rally. Unfortunately, the case looks weak.

Cautious or outright bearish views on the market rarely rested on the recovery failing to gain traction – but rather that major indexes already reflected a lot of good news following a rally of nearly 200 per cent over five-and-a-half years.

The S&P 500 now trades at nearly 18 times reported earnings. That's well above the long-term average of about 16 times earnings, raising questions about whether U.S. corporate earnings can rise fast enough to justify the lofty multiple.

There's not much evidence it can. Goldman Sachs actually lowered its expectations for companies in the S&P 500 this week. Although strategists see earnings rising 9 per cent in 2014, they expect growth will slow to just 5 per cent next year, down slightly from an earlier estimate.

That's not a disaster, of course, but it's hard to imagine how slowing earnings growth is going to translate into a late-year surge for share prices.

The thing is, large U.S. companies generate a lot of their sales from outside the United States – 30 per cent in the case of the S&P 500.

Yet, the stronger U.S. dollar, a limping euro zone economy and declining economic growth in China are making this foreign exposure look like a liability right now.

Shifting monetary policy may pose an even larger obstacle. Investors remained remarkably calm as the Fed tapered its monthly bond purchases this year, even though this remarkable stimulus was widely acknowledged as fuel for the ongoing stock market rally.

Now, though, investors are going to have to deal with another shift, in the form of rising interest rates. So far, the Fed is sticking to its line that it will leave its key rate unchanged "for a considerable time."

However, the more confident it sounds about the U.S. economy, the nearer those rate hikes are likely to appear.

"The Fed may still be saying that it will be a 'considerable time' before it begins to raise U.S. interest rates, but several small changes to the language of the latest [monetary policy] statement supported our long-held view that the first hike will come sooner than generally anticipated," said Julian Jessop at Capital Economics, in a note.

He figures March is the most likely starting point; BMO Nesbitt Burns sees June.

Either way, that will mark the first initial rate hike in more than a decade. That's an eternity for investors, and a big source of uncertainty.