Have we seen the top in the stock market with a rejection of S&P 1700, stalled earnings and mixed economic data? In short, is the bull market dying?
Not a chance. I am here to make the case that while a bigger correction than we’ve seen in over a year could be on the way, this stock market is still destined to make new highs.
In fact, as the S&P slipped below 1600 in June, I made the call that we would see “S&P 1800 before 1400.” And I still believe that this 4-year old bull market is not done yet. Here are 3 big reasons why…
1) The Fundamental Case
With banks healthy, housing strong and job growth building momentum, the chances of seeing GDP over 2% in the next few quarters is much greater than the odds of a recession. QE has achieved its purpose and now Ben Bernanke can ride his money-printing horse off into the sunset.
While corporate revenues, margins and earnings seem to have stalled somewhat, the economic underpinnings support business growth into 2014. And that’s what will keep equity valuations attractive. We are nowhere near a “euphoric” valuation level with the S&P 500 trading at just 15X next year’s conservative estimate of $110 EPS.
Though the sector and industry outperformers may change, aggregate earnings growth will set nominal records for the S&P 500 above $105 this year and maybe even above $110 next year. That means small and mid-cap indexes — “the other 2,400 stocks” — will be along for the ride too.
How do we get to S&P 1,800? As investors continue to “pay up” for growth and the market multiple climbs over 16X. Here’s the simple math: 16 X $112.50 = S&P 1,800.
And the one dynamic of this economic recovery that has not been unleashed yet is large-scale capital spending. Corporations are still hoarding their cash, as if the next recession is around the corner. But as interest rates get back to normal, and banks start to lend more, capital investment will begin to rise just like the housing recovery that snuck up on everyone in 2012.
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2) The Technical Case
The big picture from the charts is this undeniable fact: Long-term breakouts galore in all the indexes are not a fluke. This bull is still strong and even convincing the fundamental bears.
Why? Because the people doing the buying are not dummies. They are professional portfolio managers who use bottom-up quantitative skills to analyze companies and pick which 10, 50 or 100 stocks they find most appealing from among thousands. More on these folks in a moment.
Let’s go over what is significant in some of the major stock indexes breaking out to new highs. The benchmark S&P 500 surpassed the 1560-75 area that marked tops in 2000 and 2007 and has since tested that level with a 7% correction in June, finding responsive buyers.
But by far the most exciting breakouts in indexes this year occurred in “the other 2,400 stocks,” the Russell 2000 Small Caps and the S&P Mid-Cap 400. While many pundits wring their hands about QE driving speculation in smaller stocks, I see economic growth, technological innovation, M&A and competition driving earnings and valuations in young, high-growth or game-changing companies.
And all of this is reflected in the prices of strong stocks leading strong indexes. As I learned in my currency trading days, where I competed directly against the biggest banks and hedge funds in the world, “price precedes fundamentals.”
In other words, lots of information is getting discounted all the time in stocks and when price moves before the worry is gone and the smoke is clear, it is often a great predictor of what the fundamentals mean.
3) The Institutional Behavior Case
Institutional portfolio managers (PMs) must use their cash to buy equities, and they will continue to buy them aggressively as long as all the other alternatives are worse than mediocre: cash, bonds, gold, real estate, foreign markets.
After they adjust and adapt to higher interest rates and less QE, we will see another strong wave of allocation to the best asset class on the planet: US stocks.
Other than being obligated by their mandates to deploy capital in stocks, what is driving the optimism of PMs? Their belief in their ability to pick good businesses that can ride the next wave of consumer spending trends, emerging markets growth or technology innovation.
To do so, they build forecasting models that allow them to project what certain economic and business conditions would do for certain industries and stocks. These forecasts then give them some degree of visibility about the earnings potential of certain companies over others. Then they study those businesses intently, tearing down the balance sheets, visiting the headquarters, talking to management, suppliers and customers.
And when you have hundreds of PMs commanding literally trillions of dollars in investment wealth all competing for good prices in a few thousand stocks, it’s easy to see why equities have run so far this year. No PM can afford to be left behind when the bull train leaves the station next time.
Since this major trend of money pouring back into stocks is not over, you can expect new highs in the next six months.
But Aren’t We Overdue for a Correction?
While I can’t guarantee we make new highs, I can tell you that I plan to work very hard to be on the right side of whatever trends unfold this year – even if that is a change in the long-term trend of this bull market, which I see as unlikely right now.
Many strategists are worried now that the economy and the stock market can’t make it on their own without the Fed’s QE programs. And that means they are expecting a big correction to take place, especially as we head into the weakest time of the year historically with Washington debt and budget battles on the horizon.
A correction might be in order to wring out speculation excesses and high levels of margin debt. But after that big pause, I still see “S&P 1800 before 1400” in the next nine months. The fundamental, technical and behavioral forces I’ve described will all make me a buyer when stocks go on sale again.
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Kevin, a Senior Stock Strategist at Zacks, is a recognized authority in global markets and renowned for predicting market swings. A former market-maker in the $4-trillion-dollar-a-day world of interbank trade, he developed the ability to track the movement of money, and trained his reflexes to take advantage of it. Today he directs the Zacks Market Timer, providing commentary and recommendations.