Financial outlook for 2013.

• Author: Masson, D.J.
• Position: Economic Fundamentals of financial markets

Last year we wrote about the roller coaster ride caused by the European sovereign debt problems. While this "beast" is still in the picture, we predict that the 2013 financial markets will be driven more by earnings than by fear.

Earnings are relatively high, but the third quarter numbers were disappointing. In the 12 months ending in October 2012, the S&P 500 index rose about 13 percent. While this return was much higher than for the same period last year, we have lost about half of this gain since the election. It seems that the election was not a positive factor for the market. There are two possible reasons. One is that the market thinks the Obama administration will be less friendly to business in its tax and regulation policies. The second is that the market is concerned about the uncertainty from Washington. The election did not end the partisan bickering and markets do not like uncertainty. We cannot determine which factor is dominant but we expect that both are likely to continue. With this as a background, we turn to fundamentals.

Economic Fundamentals

Stock prices are a very good indicator of future economic activity: investors buy stocks anticipating the real economy will pick up in the near future. There are many positive signals that suggest optimism for 2013.

* Corporate earnings are still generally high. Third quarter earnings for 2013 were disappointing for some industries and companies, but more companies are reporting a positive earnings surprise than a negative one.

* Price-earnings (PE) ratios are close to historical averages, suggesting that stocks are not overvalued. The PE ratio based on current earnings for the S&P 500 is currently 15.9, just below the long-term average of 16. The PE ratio for the projected earnings of the S&P 500 is 12.6, which is below the average value of 14.3 over the past 10 years.

* Major U.S. banks are stronger than their European counterparts. The stories out of Europe are about the weakness of bank balance sheets mostly in Spain and Italy--but we hope not Germany.

* The Federal Reserve is continuing to keep interest rates low to fuel the economy. The Fed Funds target rate of zero to 0.25 percent will probably be maintained throughout 2013, and the 10-year bond rate will likely maintain its current range of 1.5 percent to 2.0 percent.

* The dollar has been strong since last year but weaker over the past three months perhaps in response to "quantitative easing III." Its current direction is a...