U.S. stock markets are taking a short break today for the Independence Day holiday and it gives us an opportune moment to look at where markets have been this year and where markets are going.
So far, the Dow Jones Industrial Average (^DJI 0.40%) and S&P 500 (^GSPC 1.02%) have returned 8.5% and 4.2% respectively, but that hasn't been because of a booming economy. In fact, the economy shrunk in the first quarter, which means investors are pricing in growth in the second half of the year when the economy is expected to pick up steam.
Where we've been
The year 2013 was highlighted by a fast rising stock market, but that was driven by optimism for an improving economic future. That confidence and optimism was put to the test in the first quarter when markets slumped to start the year and the economy shrank 2.9%.
Despite the poor numbers, everyone from consumers to the Federal Reserve seemed to see better days ahead for the rest of 2014. The Conference Board's Consumer Confidence Index hit 85.2 in June, which is the highest level since January 2008 when the economy started to implode. The Institute for Supply Management said its non-manufacturing index was 56.0 in June, indicating economic expansion, and Markit's service-sector purchasing managers index was 61.0 in June, the highest since October 2009.
Economists are bullish on the economy for the second half of 2014.
So, the first half of 2014 has been marked by some negative economic data, but high confidence has continued. One reason for that may be a steadily falling unemployment rate, which dropped to 6.1% in June and consumers are confident they can drive growth in the future.
What to watch in the second half of 2014
With the fairly weak GDP data but high confidence in mind, I look at the second half of 2014 as being when the rubber hits the road. If economic growth doesn't pick up as expected, markets could retreat. And with so much optimism priced in, it's time for the economy to start proving that the rally over the past 18 months is built on a solid foundation.
But that's where I think we'll start seeing some positive trends. First, the unemployment rate is finally low enough that power will begin shifting to workers, who may be able to demand higher wages than they could have when even finding a job was difficult. If that happens, people will have more money to spend and the economic engine can get fired up again.
If spending improves, companies will have an incentive to put the billions of dollars on corporate balance sheets to work by investing in future growth. Growth could be a reinforcing loop that feeds on itself.
Foolish bottom line
Considering the recent data surrounding confidence and employment, I think the economy will begin growing again. The first quarter was somewhat of an aberration because of bad weather throughout the country that kept consumers home.
On an economic front, the best is yet to come for the U.S. Whether that translates to continued record highs for the Dow Jones Industrial Average and S&P 500 is another story. Only time will tell if an improving economy is enough to keep stocks moving higher in the second half of the year.
