Halfway Home for Stock Market Rally
The string of recent economic data has been productive, but much more is needed to get us out of the muddle through that is our current state.
-- Teddy Roosevelt
Throw the flag! An off-sides institutional investment community, coupled with confusion and contagion at the top of the brow has allowed hope to guide us higher, although we are destined for a date with further deterioration in the distant future. The purpose of this process is not to side with the psychology of a bull or a bear. It is an objective process conditioned by gauging the facts to determine the best probability of an outcome.
We are halfway home with my prediction for a 20% stock market rally that commenced at the end of 2011. Last December, I offered in a not-so-eloquent video my thoughts for this out-sized rally in equities. As we tiptoe toward my near-term price target of S&P 500 1365, I would like to distinguish my thoughts on where we stand and a likely path going forward.
On October 4, 2011, based on earnings over the trailing 12 months, the P/E ratio for the S&P 500 index stood at 11x times versus the long-term average over the last 130 years of 16.3 and a median of 15.7, and the stock market provided a discount to fair value, an opportunity to exit short positions and add to long-term market exposure.
With the S&P 500 positioned at 1082, I offered the notion for a rally to ensue into year end and present day. To this investor's surprise, I did not forecast the voracity with which we would meet my target of 1265-1285. As this measure was met in less than one month, I cautioned those looking for continuation to expect further upside, but a pullback was to commence and it did. (See The Latest Stock Market Recovery Is Destined to Disappoint.)
It has been my consistent belief since defining a multiyear bottom in March 2009 that we are in a bear market rally, one that has lasted 35 months. The goal of this rally is to lure investors and disbelievers back into the market and convince them the worst is behind them. It has done a remarkable job and it isn't finished yet. We are likely to see a pullback in the short term; the S&P 500’s current P/E ratio stands at 15.13, while the Dow Jones Industrials’ P/E comes in at 13.77.
This would be considered fairly valued, coupled with the elevated number of stocks trading above their 200-day moving average. This will allow us to identify the strength of the market and analyze potential additional upside. Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. It is with this understanding that I believe our markets will trade back toward their all-time highs, S&P 500 1525-1550.
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The euphoria I anticipated at this current juncture in the market, coupled with investor sentiment, has not manifested to warrant such a dramatic end to this multiyear bear market rally.
US stock mutual funds had their second-worst year in 2011 as investors fled the market’s volatility and into the perceived safety of bond funds. Bloomberg reports an estimated $132 billion was pulled from mutual funds that invest in US stocks. This marked the “fifth straight year of withdrawals for domestic funds, according to preliminary data from the Investment Company Institute.” The worst year on record was 2008, when investors pulled $147 billion from US mutual funds.
From 2007-2011 retail investors sold $450 billion domestic equity funds and purchased $930 billion bond funds, a startling $1.4 trillion difference. The long-awaited reallocation out of fixed income investments will begin to take form and provide a rotation back into the stock market; historically the stock market peaks with the 10-year US Treasury yielding 4%. Additionally, this past week’s ISI report highlighted the hedge fund community "smart guys" net long exposure stood at 44.3%, its lowest level in four years and equivalent to the March 2009 market bottom.
Thus it is likely we witnessed a March 2009-like bottom on the back of Europe's debt debacle in October 2011. The European Central Bank's long-term refinancing operation (LTRO), which offers banks three-year loans at a discount against a wider-than-usual range of collateral, will avoid a Lehman-like event from breaking banks as liquidity needs are being met and contain the contagion.
Finally, to address funding pressures internationally per the New York Federal Reserve, the Federal Reserve reintroduced a system of reciprocal currency arrangements, or “swap lines,” with other central banks. The swap line program enhances the ability of these central banks to provide US dollar funding to financial institutions in their jurisdictions. What are risks to breaking up this rose-colored scenario? Risks are plentiful and should not be ignored. Currently the greatest risk to derailing the market's potential rise is geopolitical.
Tensions are escalating between Iran and Israel; a weekend report by The Washington Post suggests a violent conclusion to political posturing. My view is crude oil will continue to hold a fear premium, and as we approach a seasonality bid to WTI, the oil market looks destined toward 2011 highs.
Although in the short term crude oil's rise will provide a boost to equities, it will also act as an eventual headwind to the consumer and dampen struggling GDP growth. It is no secret that investors know where I stand on a lackluster economic recovery that has been injected with trillions of accommodative dollars by the US government, which has produced paltry annualized GDP numbers. In 2009 it was -2.4%, in 2010 it was 3.0%, and last year it was 1.7%.
The string of recent economic data has been productive, including Friday's impressive nonfarm payroll number. But much more is needed to get us out of the muddle through that is our current state. Under the Clinton administration, nonfarm payrolls saw an average increase of 250,000 for his entire term as president. Printing our way through problems is not a sustainable solution and has created a debt bubble that will ultimately grow to an unsustainable burden. The current US debt ceiling of $16.394 trillion or roughly 100% of GDP as compared to Greece’s problems began when its debt reached 130% of GDP. It is likely the US will hit a national debt equal to 130% of GDP in 2015, if austerity measures are not introduced.
My road map for such a pullback should be given small consideration through the lens of time rather than price. With the crowd looking for a dip to be bought, there must be attention provided toward a classic bull market move in which stocks grind higher and consolidate overbought conditions through time vs. a dip in actual price, what we have experienced during this current rally. A corrective course likely will be bought up along the way, and there are floors being constructed much like a stair approach at 1330, 1300, and 1265. If we are to break through the stair case, then Mr. Market is telling us to square up our positions. My longer-term market forecast of 950-880 remains intact and will continue to be viewed on an 18-month time horizon.
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