Goldilocks Cubed Update: The data to date is 'just right'
As regular readers of my pieces know, we’ve been bullish on equities for a very long time and believe we have now entered a promising phase in the secular bull market that we call “Goldilocks Cubed.’’ The three components of this thesis, in brief, are accelerating earnings, stable global interest rates and prolonged low volatility. The past few weeks have only served to strengthen this argument and, if anything, have elevated the risk to the upside on our longstanding call for the S&P 500 to reach 2,100 by year-end. Our intermediate target remains at 2,500 over the next two to three years, a 25%+ increase from current levels. Current evidence reinforcing our view:
- Economic growth. The numbers continue to come in better than expected, with jobs, auto sales and manufacturing particularly strong. We think we are long beyond the post-winter bounce and instead have entered into a more prolonged period of 3% to 4% real GDP growth. While this week’s economic calendar is relatively light, the regional Fed surveys should follow the path of last week’s very good Empire and Philly readings. Housing is likely to be just OK, but jobless claims are expected to trend lower while durable goods orders on Friday should close the week on a positive note.
- Earnings. The second-quarter reporting season is off to a good start, with full-year numbers being revised up, not down, in mid-summer for the first time in quite a while. Two weeks into earnings season, consensus estimates on the S&P have actually risen to our longstanding $120 target for the full year. U.S. banks and tech have led the way so far, but this week, we will be getting broader input from other sectors and expect this news to be good.
- Bond yields. They have remained low despite the economic acceleration. Low and/or slowly rising bond yields in the face of accelerating earnings is a great Goldilocks recipe for stocks, and this is the porridge we’re being served. Fed Chair Janet Yellen’s concerns about long-term unemployment are only part of the driver. The rest has to do with global supply-and-demand imbalances for risk-free assets. Lingering concerns about a 2008-09 style meltdown in equities and ongoing geopolitical risks have driven up global demand for risk-free assets. Ironically, while the U.S. Treasury bond is viewed as one of the best defenses against risk in the world, its yield is still substantially higher than other havens such as Germany and Japan. We think these global forces will keep our bond markets stable even as the economy picks up.
- Risk fears. We think risk perceptions are still too high and will continue to grind lower. This gap can be measured in different ways using the VIX—or “fear’’ gauge as many call it—but quantitatively, it is interesting to note the forward curve on the VIX has volatility going higher over the next few months, not lower. This is consistent with anecdotal evidence that many investors see volatility right now as “abnormally low” and expect an anvil to drop from the sky any moment. We think the more probable outcome is that volatility actually stays at current levels or even drops lower over the next two to three years. Although a 10% to 12% VIX seems very low relative to the financial crisis years from which we’ve just emerged, relative to more stable periods, i.e., the mid 1990s and mid 2000s, it’s actually pretty normal.
Putting all this together, we think the trailing P/E multiple on the S&P should rise to 17.5 times by year end, which at $120 in earnings gets you to our 2,100 target. We haven’t changed this idea since last fall. Longer term, we see the multiple creeping even higher (toward 20) against a backdrop of high single-digit earnings growth. This is good for domestic stocks, particularly ones that can convert economic growth to strong earnings growth, such as industrial cyclicals, franchise tech companies and certain energy stocks. We are buyers of any dips, especially ones driven by geopolitical concerns (i.e., Gaza, Ukraine/Russia), which we view as short-term distractions, not long-term problems. We are in a bull market, so we don’t advise selling rallies in anticipation of corrections—these are often shorter and shallower than hoped for.