Market Memo: Bears in bull clothing finally capitulate
For some time—years, actually (Oct. 28, 2011: “Equities for the longer run;’’ May 24, 2012: “A new secular bull”)—we’ve complained that too many of the so-called market bulls were really bears in bull clothing. They would recommend equities for the short term due to favorable central bank action but at the same time issue dire warnings the world could end at any minute. From their perspective, the market would peak at the infamous 1,565 double top on the S&P 500 (from 2000 and 2007), then retest the old 2009 lows.
We’ve argued that this underlying bearish stance has contributed positively to the “Wall of Worry” that the market would climb, and that eventually we would pierce definitively the infamous double top. And when this occurred, there would be melt-up as the bears in bull clothing capitulated.
Today’s action, blasting us through 1,600 on the S&P, may prove to be the final straw for the bears. We are continuing to recommend investors stay overweight equities, and particularly focus on those areas of the market most exposed to the global economic cycle: tech, industrials, materials, and emerging markets.
Here are some key points behind our thinking:
- A strengthening underlying economy While the macro data of late has been mixed, on balance, it’s constructive. The weakness appears to be driven by short-term factors, such as the unseasonably cold and stormy March and early spring, and the one-time tax hikes arising from the fiscal cliff and sequestration deals. This has blurred a much brighter picture in key segments of the economy, led by a recovery in housing, the return of buyers to auto showrooms not just out of necessity but for fun, and a growing domestic energy sector. We expect these critical elements to shine through in the second half. For example, residential and nonresidential construction alone used to be 9% of GDP, nearly double current levels. This morning’s surprisingly robust jobs report, relative to expectations, is another indicator of this strengthening. Our leading indicator model at Federated has been flashing green for the last month.
- More global central bank reflation Japan has finally joined the party under Prime Minister Shinzo Abe, who has embarked on an unprecedented and aggressive plan to stimlulate Japanese growth, including the dumping of more yen on the Ginza than even “Helicopter Ben” on the U.S.—his QE package is 2.5 times as large as the U.S.’s relative to GDP. And Japan is not alone. This week, the conservative European Central Bank unexpectedly stepped in and cut rates for Europe to a record low, adding to global liquidity.
- Cyprus may be bear case’s final straw Our upside 1,660 target on the S&P for this year has largely been driven by the idea that as the year progressed, investors would increasingly come to believe the “next Lehman” isn’t going to happen in this cycle, and that as they realized this, they’d be willing to pay a higher multiple for equities. Cyprus may have been the final straw for these bears, convincing many that waiting for the sky to fall is going to be a long wait. The market corrected just a couple of percentage points on Cyprus (compared to 10%+ on previous false signals of impending doom over the last four years), and has since rallied hard, up 4% since mid-April. More interestingly, this move up off the lows has been driven by the cyclical sectors—finance, tech, discretionary, materials, energy—that traditionally mark the next stage up for a market.
- Earnings have been ‘good enough’ With the earnings season almost over, we’ve had a fairly normal share of bottom line beats (75%), though guidance has remained cautious. But what we like is that downward revisions for forward earnings, which were sharper earlier in the year, seem to be bottoming for many cyclical names. This is a very positive sign, particularly given current low valuations.
- ‘Triple-top’’ technicians may throw in the towel For the last three years, we’ve been talking about this: the ominous double top in the S&P from 2000 and 2007. We think the fear of this level has partly caused many technical analysts, and even fundamental macro ones, to be “bulls in bear clothing.” The thinking was equities would rally to the double top, make a triple top, then rollover to retest the old 2009 lows. Today’s action, if we close above 1,600 which appears almost certainly to be the case, may mercifully be the bullet in the brain of this idea. This will force the technical guys in, and could lead to an upside melt-up.
Where are we going?
We think the rally from here out is going to be about the area of the market that has performed least well—cyclical and emerging markets—abetted by strengthening U.S. and Chinese economies in the second half, more aggressive easing all over, and less austerity in euro land. While there is not much upside left in 2013 against our 1,660 target, we think the way we get there is a rotational shift out of defense and into offense, which is where the remaining value is in the market. We think many stocks in this space have 10% to 20% upside in a melt-up scenario.
On a longer term view, we remain convinced that the “secular bull market” we’ve spoken of in these pages—which should take the S&P to 2,000 and beyond over the next several years—is very much intact. While we have not yet revised up our 1,660 target for this year, we expect longer-term investors to be well rewarded for buying stocks, even at present levels. If the melt-up continues, we could get there sooner rather than later.