Bull market prolonged by sluggish economic recovery – it has more upside potential

Posted by Shyam Moondra

In recent months, the “overheated” bond market has declined with a sharp increase in the yield of the 10-year Treasuries, while the stock market has traded in a narrow range. The bulls are frustrated because the broader stock index DJIA is not moving up faster with heavy volume and the bears are disappointed because the market is not having the expected big correction of 10-20% even after a long bull-run over the last seven years. That leaves the stock market in a limbo and many investors are not sure how to trade, which is apparent from the declining trading volume.

Below is a synopsis of various economic and political factors that suggest that the stocks still have an upside potential and we might see DJIA surpassing the 19,000 mark in the coming months:

·         The economy has been recovering from the financial crisis of 2008 at a tepid annual rate of 1-3% (historically, post-recession recovery rate of 4% is not uncommon), which has prolonged the recovery period beyond the usual four to five years. An over-heated economy coupled with out-of-control commodity markets are a pre-requisite for an impending recession; however, at the present time, we have neither and as such we could see continuing sluggish economic recovery for another couple of years.

·         The jobs numbers have been good but not very strong and, therefore, even after seven years of recovery, we are still not close to the full-employment level (i.e., unemployment rate of 4.5%). As a result, the wage inflation has thus far been negligible, which has allowed the corporations to keep their costs down and allowed FED to defer any increases in the funds rate, thereby continuing with their accommodative monetary policy.

·         The inflation continues to be very low and within the FED’s targeted range, thanks to the decline in oil prices. Given that commodity markets are not over-heated (even after seven years of economic recovery), it’s reasonable to assume that inflation will remain in check for the foreseeable future. Low inflation is always good for the stocks.

·         In recent weeks, the bond market has declined (after an extraordinary bull run that created the bond bubble) with the interest rates spiking up but they still remain below historical levels. Given lower inflationary pressures, the FED is expected to increase the funds rate in small increments starting this year; however, the market has already discounted the first couple of small increases that are likely to take place in September and December of this year. The market will wait and see how these increases continue next year in terms of their magnitude and timing before reacting to interest rate increases. Since next year we have the presidential election, the FED is unlikely to change policies drastically and give the perception of taking sides; therefore, the FED will continue its slow and steady approach at least through 2016. For now, so far as the interest rates are concerned, the stock market has a green light to continue its upward march. As the bond bubble bursts, some of that money could end up in stocks and help with the bull-run.

·         The stock market recovery has also been slow coincident with sluggish economic recovery, which explains why even after seven years of a bull run, the market is not overheated and the stock valuations are quite reasonable. The forward PE of 15.94 for DJIA, 17.81 for S&P 500, and 19.45 for NASDAQ are not excessive and they are much lower than what they were at the market peaks of 2000 and 2007 (when they were in the high-20’s to 90’s range). Also, the current common stock dividend is higher than a year ago and is very attractive compared with the bond yields. Therefore, a case could be made that bonds have room to go down more and stocks have room to go up more.
 

·         The auto and housing sales continue to be very strong, mostly because these markets were hurt really badly by the financial crisis and there was a huge pent up demand built up over the last few years. The current strong demand for auto and houses mean that economy will continue to grow in the foreseeable future and the stock market will keep going up with them.

·         In recent years, European countries have taken unprecedented austerity programs to cut government spending, which, in the near-term, has proven to be painful and it has even slowed down economic growth; however, those sacrifices are beginning to pay off and it is expected that the European economy would start picking up the pace in the coming months. The QE program recently started by the European Central Bank will also help revive the EU economy. Also, strong dollar is increasing the European exports to the U.S., thereby giving a boost to their economy. In the intermediate-to-long term, strong European economy will spur global growth which will also benefit the U.S.
 

·        We have just begun the presidential election season and this time financial markets would be   more sensitive to who is elected as the President than ever before. President Barack Obama is viewed by many, perhaps unfairly, that he is anti-business. Therefore, businesses may favor a business-friendly Republican in the White House, who might reduce taxes, streamline government regulations, and spend more on military.

·         Some of the specific sectors that could be the leaders in the next phase of the bull-run for the stocks could include banks, military system manufacturers, and technology companies.

Given that interest rates are likely to go up this year and next, the banking sector would see their interest spread increase and thus help boost their profitability. The bank stocks, which have gone up in the last couple of weeks, will benefit from interest rate increases and may lead the new bull phase of the stock market. Many banks are currently selling near or below their book values; they could easily move up to at least 1.2 to 1.4 times their book values, assuming we would see more increases in their dividends and buybacks of their own shares in the coming months. If a Republican wins the White House in 2016, it’s safe to assume that bank regulations emanating from Dodd-Frank bill would be scaled back, which will greatly reduce banks’ operating costs and make it possible for them to take greater risks than they are able to do now by lending more to small businesses that could help create more jobs

Recent geopolitical developments such as Russia’s illegal annexation of Crimea, China’s aggressive policies in the South China sea, and the turmoil caused by the Islamic militants in the Middle East and Africa have prompted countries around the world (including the U.S.) to increase the budgets for their defense departments. The U.S. military systems manufacturers are likely to see increased demand for their products and services worldwide over the next several years and thus could become one of the leading sectors to push the stock market up. Given that Republicans favor strong defense, if a Republican is elected as the next President, the stocks of the defense manufacturers would get a big boost.

Although NASDAQ set a new record high last week (beating the last record set back in 2000), the forward PE is only 19.45 compared with 90 in 2000. This suggests that the technology sector could also be one of the leaders that will take the broader stock market to new record high levels in the coming months.

Given that the current stock valuations are not excessive and that we will continue to have low interest rate/low inflation environment for the near-term, the stock market has more room to go up at least for the rest of this year and early next year. At some point in 2016, depending on if a pro-business candidate is elected as the President and depending on inflation situation and how aggressive the Fed is on increasing interest rates, it is possible that we may finally see a correction that many bears have been expecting. But for now, the stock market may continue its slow upward march towards DJIA of 19,000.

DISCLAIMER: The blogger is long in the sectors mentioned in this blog.