'Boo!' It's the secular bull, still running over the bears ...
The equity rally that kicked off early last week and accelerated on U.S.-China trade headlines reinforces the out-of-consensus view we laid out amid last December’s sharp sell-off: that 3,100 on the S&P 500 is likely by year-end this year, with a further move up in 2020 that should take us to our longstanding target of 3,500. The primary reason remains the same as we first brought up nearly a decade ago: we are in a secular bull market. Until that fundamental fact changes, volatile and worrisome periods that bring the bears out in full force represent buying opportunities for calm-minded bulls. Stocks continue to be supported by dovish central banks, historically low bond yields and favorable fiscal policies. Nearer term, we think the economic slowdown is nearing an end and that the rally that began last week in financial, industrial and technology cyclical stocks has legs. If anything, the risk to our year-end target primarily is to the upside. We see several factors behind this view, including:
- The global manufacturing slowdown has likely bottomed or will soon. German industrial production started declining a year ago, and will soon lap weaker numbers. More broadly, global leading indicators have been steadying of late, signaling stabilization and a bottom. In the U.S., the closely watched manufacturing ISM began decelerating 11 months ago, with September’s very low reading likely the near-term low point. This view was reinforced last Friday by bellwether Fastenal Co., which makes and sells industrial equipment. Its sales for the quarter climbed 8%, and notably, its earnings topped forecasts, a sign things are getting less worse, i.e., the manufacturing economy is at an inflection point and the news should get better from here. Combined with the much-larger consumer side of economy, which remains positive as reflected in last week’s surprise bump up in Michigan sentiment, we foresee a strong Christmas ahead. Further reinforcing this point: this morning’s better-than-expected earnings from JPMorgan Chase and Citigroup on strong performance in their consumer businesses.
- The U.S.-China trade situation is getting “less worse’’ and, given very low expectations, that’s really all that is needed. A key issue is both sides have strong economic/market reasons to do a deal, and strong political reasons not to. This means that reading the signaling going forward will be tricky. China we think agrees with more of Trump’s demands then it lets on but can’t appear to submit to his ideas in a “humiliating” surrender. Trump needs relief for the Midwest industrial and agricultural economy but can’t seem to be letting the Chinese off easy. So look for both sides to save face by doing deals in the weeds, not on the main lawn. For example, we think the most positive thing about last Friday wasn’t the friendly tone of the press conference but the “independent” announcement earlier that morning that China was pulling back its longstanding requirement that financial firms have a 50% Chinese partner. This key element of the Trump administration’s intellectual property fight was suddenly surrendered but positioned as China’s own idea. Bottom line, we’re past the nadir of the trade tensions.
- Valuation is attractive, especially relative to longer-term expectations of where the 10-year Treasury yield will settle. Over the last year, those market expectations have moved down from 3-3.5% to 2-2.5%, yet the implied revaluation of stocks hasn’t happened yet. We think that could be the next big market driver, especially in beaten-down value stocks in the Financials, Industrials and Semiconductors sectors that also would benefit if the economy began re-accelerating next year. Stock by stock, the most cyclical names—especially in Industrials and Semiconductors—already have seen significant corrections of 8% to 20%; the overall market never corrected this much because of the rush to defensive stocks that drove them up even as the cyclicals were going down. So market internals suggest this current correction is over.
There are other favorable factors. Regardless of how it’s characterized, the Fed’s quantitative-easing-lite—sort of a reverse “Operation Twist” that in this case is being used to drive down short yields vs. long yields—has begun to steepen the curve. While the bears are still growling, there’s a lot less hysteria lately about the negative sloping yield curve and “the coming recession.” Further, another source of global uncertainty, Brexit, appears to be coming off the table, right on cue. Reports today that the U.K. and Europe are close to a deal are adding another leg to the upside potential of this market. But even if those talks fail and there is a “hard” Brexit, this has been bandied about for so long that a relief rally is still likely, at least temporarily. A final contrarian positive—very negative market sentiment. We think this is likely due to “recency bias” related to last year’s fourth-quarter sell-off that destroyed what had been a good year. We don’t expect it to happen again for the reasons above and for the reality that most fourth quarters are good for stocks. So as the market heads into the final two months of the year, we recommend that the long-term diversified investor stay overweight in stocks. This secular bull isn’t finished yet. Plenty of bears yet to run over as it climbs the Wall of Worry.