With the U.S. markets trying to hold on to some gains this year, many experts and gurus fear a stock market crash is imminent. We disagree. While the U.S. stock market may be a bit on the high side it is not stretched. The gurus are quick to point out that corporate earnings are declining, which they have, and the rest of the world is experiencing an economic slowdown. While all of this, from a fundamental outlook, appears plausible, everyone seems to still agree that a recession in the U.S. is far off and the least likely of outcomes. What is important to recognize is none of these facts are unknown to investors. Every investor sees the same things. The difference is in how they interpret the data.
Throughout the history of the stock market all major market tops have a number of similar characteristics:
1) The stock market has had a substantial rise over a long period of time.
The present bull market is seven years old and is the third largest run in longevity and amplitude. We have seen a number of relatively benign (5%-7%) to comparatively strong (10%-19%) pull-backs, followed by reintroduced advances and new highs; proving, time and time again, that the age of a bull market alone is not an indicator of a major market top.
2) Investors are very bullish at market tops, predicting more substantial gains.
We hear this on TV as “the new paradigm”. Investors are convinced the market is only going higher. The only fear is the fear of missing out and the use of leverage to buy even more securities is rampant. However, we are far from seeing or hearing anything like that now. Despite a seven plus years long bull market, we have heard mostly pessimistic and negative comments. Even after a 200% return from the lows and breakouts to new highs, we have yet to hear anyone saying “we are in a new paradigm.”
3) The economy is moving along briskly and corporate profits are strong.
Looking at the above three characteristics, we certainly agree that the market has had a substantial rise, but the other two have yet to happen. While we don’t expect to see a steep decline in the stock market, that does not mean we are poised for a strong advance either. We believe the market will trade in a range of 1800 to 2100 on the S&P 500 until investors see accommodative fiscal policies and the prospect of corporate earnings growth. When that occurs we will see the market break out to the upside.
One might ask: Why is the market not going down given the dismal short-term outlook for corporate earnings? Our opinion is that, even with sluggish economic growth, corporations are able to throw off cash flow in the form of dividends and, given today’s stock prices, the dividend yield is better than that of a 10-year U.S. Treasury bond. So why not hold stocks that will increase earnings and dividends over the next 10 years rather than a 10-year Treasury bond? It is our opinion the probability of an earnings growth breakout within the next 10 years is highly probable.
We welcome your questions and comments. Have a wonderful Memorial Day weekend.
May 27, 2016