6 Reasons The Market Is Going Much Higher

Includes: JNJ, UPS
by: Larry Smith

I had a few days off last week and I spent a lot of time examining the overall market. I am always looking for stocks, but recently I have been concerned the market is getting ahead of itself, so I did a lot of research on market valuation, economic trends and corporate health. As I did this research, I came to one overwhelming conclusion, I believe over the next several years, U.S. stocks will go much higher. I emphasize U.S stocks because I believe other parts of the world, especially Europe, have many issues that need to be worked out.

Before I explain why I think stocks will go much higher, I want to state that this is just my opinion, I am not a market guru, I have not called the last three market crashes, I am not a frequent guest on CNBC, and in fact, I usually do not concern myself with market direction. The only reason I started examining the overall market was because I have some money to invest and I did not want to put the money to work if stocks appeared way overpriced. Although I am a dividend growth investor, mostly concerned with income growth, I do not see any reason to buy stocks if they are overpriced. Better to wait for a pullback and be able to buy a few additional shares, than to buy overpriced shares today.

I have said before and still believe as I write this, no one can predict market direction, there are too many variables and too many black swans. However, as I did my research, I kept coming to the same conclusion, that the United States economy and stock market had the opportunity to embark on a multi-year period of growth and higher stock prices. That does not mean we will avoid market pull-backs, or periods of flat performance. I also know there are all sorts of events that could occur that could turn the market down for an extended period. As former Secretary of Defense, Donald Rumsfeld said, "we don't know, what we don't know". However, with a little luck, I believe the U.S. economy and U.S. stock investors are on the verge of a perfect storm of economic growth and stock market appreciation.

1 - End of Quantitative Easing - The day will come when the Federal Reserve stops quantitative easing, I do not know when, but I do know at some point it will end. I am not smart enough to know when, it might be this summer, it might be this fall, or maybe it will end next year. When it does, or when the Federal Reserve announces their intention to end easing or cut back the size of their purchases, I suspect there will initially be a stock sell-off as market participants decide the stock market cannot stand on its own. However, I believe this will be short-lived as the bond market will see a sell-off far greater than what will occur in stocks. When investors start fleeing the bond market, I believe much of that money will find its way into the stock market.

When the quantitative easing ends and bond rates start to rise, Treasuries will be the worst investment around. Investors who hold Treasuries do so for safety and security. When these investors pull their money out of bonds what options will they have? Certificates of Deposit will still be paying little or no interest, commodities are volatile, emerging markets, real estate, etc. all carry above average risk. I believe much (not all) of the money will gravitate towards conservative dividend paying stocks. This influx's of new money will help push stocks higher

2 - Best economy - As I look around the world, I do not see too many economies doing better than the United States. We are not firing on all cylinders, buy we are far better off than most. China has been slowing down, unemployment is high and environmental issues continue to grow. Other parts of Asia, like Singapore and South Korea are doing fine, while some areas like Japan struggle. Europe is a mess, with much of Southern Europe drowning in debt and Northern Europe unable and/or unwilling to help. South and Central America have pockets of strength and pockets of weakness.

The United Sates has recovered from the Great Recession and continues to see improving fundamentals, unemployment is falling, house prices are rising, automobile sales have risen, hotel occupancy is up, retail sales have been solid, and factory orders have slowly improved. The recovery makes the United States one of, if not the best place to invest in the world. If you lived in Europe and had investable cash would you invest in Europe, or would you put at least some of your money in the U.S. Investors do chase performance and right now the U.S. economic and stock market performance has been among the best.

In my opinion, the economic recovery is still in its early stages with housing being the key to how strong the recovery will be. As the chart below shows, housing starts have been well below historical levels since the recession. Demand for housing has been rising and some cities report a shortage of homes for sale.

Chart courtesy of St Louis Fed

As demand for housing picks up, existing home prices rise, as prices rise, homeowners feel more confident and spend more. As the demand for housing rises, more homes get built, which creates construction jobs as well as housing related jobs in manufacturing of household goods. An improving housing market along with higher employment will add to the economic rebound and help propel corporate profits and stock prices higher.

3 - Stocks are Reasonably Priced - Depending on what source you look at, stocks are currently trading at about 14 times forward earnings. That is not bargain territory, but it is also not overpriced territory either. It is especially true when one considers S&P 500 companies have expanded their earnings three straight years and have forecast continued earning strength in the year ahead.

Although the media has been trumpeting news that the stock market has hit all-time highs, on an inflation adjusted basis, the market is below its 2007 peak and below where it stood in 2000.

For reasons I will expand on, like low energy prices, corporate balance sheets strength, and productivity of the American workers, which is always near the top of productivity rankings, I believe corporate earnings growth will continue in the years ahead which will allow stock prices to grow along with the earnings. It is earnings that drives stock prices and I believe the earnings recovery for corporate America has just begun.

As the recovery gains strength, consumer spending will increase, an increase in consumer spending leads to a pick-up in manufacturing, which will lead to higher employment, which will lead to more spending and the cycle repeats itself. Rising earnings will make current stock prices look reasonably valued.

4 - Low Energy Prices - Everyday we wake up, we should give thanks for the abundance of natural resources this country has. We have more coal, oil and natural gas combined than any other country.

Oil was first discovered in 1858 by Colonel Edwin Drake in the small town of Titusville, Pennsylvania, his discovery lead to years of growing oil production and vast wealth creation. Approximately 150 years later, fracking has unleashed another oil boom which is growing production and creating wealth. Oil production has increased for the last several years and is forecast to keep growing. The U.S. Energy Information Administration (EIA) estimates that U.S. total crude oil production averaged 6.4 million barrels per day in 2012, the highest annual average rate of production since 1997, and forecasts U.S. crude oil production increasing to 7.3 million bbl/d in 2013 and 7.9 million bbl/d in 2014, the highest annual rate of crude oil production since 1988.

Fracking has also led to the production of an abundance of natural gas, so much so that producers had to start shutting down rigs because the price fell so low it wasn't profitable to produce it. The EIA estimates that there are 2,203 trillion cubic feet (Tcf) of natural gas that is technically recoverable in the United States. At the rate of U.S. natural gas consumption in 2011 of about 24 Tcf per year, 2,203 Tcf of natural gas is enough to last about 92 years. American companies benefit greatly with natural gas prices at approximately $4.00/MMBtu compared to approximately $18.00/MMBtu in Asia and approximately $11.00 in Europe.

Although coal has become unpopular, the United States leads the world with over 260 billion short tons of recoverable coal reserves-28% of total global reserves and 50% more than Russia, which possesses the world's second largest reserves. Despite significant U.S. coal production, recoverable domestic coal reserves at current mining levels would last 222 years. Work continues on reducing coal's carbon footprint through advanced scrubbing technology and carbon-capture.

This vast wealth of energy resources allows U.S. companies to access cheap energy for heating/cooling office buildings, lighting plants and providing feedstock for manufacturing. This is a huge advantage as no other large manufacturing country can compete with the cheap energy resources the United Sates has. Japan is an island that must import most of its energy. European Governments have made carbon reduction a priority which has driven up energy costs as has the lack of available domestic supply in many countries.

The vastness of the U.S. energy resources is an advantage that will not go away in our lifetime. In fact, I believe this is an advantage that will only grow as world energy supplies become tighter and prices increase. Corporations based in the United States will have a huge cost advantage over foreign companies that may, in some cases, pay three to four times the cost of energy that a U.S.-based company does.

5 - Corporate strength - The balance sheets of corporate America have never been stronger, corporations are sitting on record amounts of cash and have been earning record profits. Obviously, not every company has been turning out record profits and piling up cash, but many companies have never been financially stronger.

Corporations, worried about demand for their products and services have been hesitant to build new plants or expand production. Thus, cash has grown and some of this cash has been finding its way back to investors in the way of stock repurchases and dividend increases. In the final quarter of 2012, 4,002 U.S. companies made announcements regarding their dividend policies a new record. Combine the record dividends with simultaneous record share buybacks that have been occurring and you have an excellent recipe for investor success.

I do not see anything immediate in the future that would disrupt the flow of cash onto corporate balance sheets and strongly believe the dividend increases and stock buybacks will continue. As the cash grows on balance sheets, investors and activist hedge fund managers push companies to return that cash to shareholders. As the cash grows, so will the calls from investors to return it to them.

6 - Fewer shares available - Below is a chart, courtesy of USA Today which shows the number of companies investors can buy stock in, as measured by the Wilshire 5000 index. The number of companies has been steadily declining as firms are delisted, go private or are bought out. In addition, the number of IPOs, which is supposed to replenish the stock market with new companies to invest in, has been weak and well below 200 a year. Thus the actual pool of stock available to investors is less.

Add in all the stock buybacks, to the fewer listed companies and it becomes clear that the number of shares available to investors is shrinking. We all learn in Economics 101, that more dollars chasing a smaller supply of a product leads to higher prices for that product.

If, as I believe, investors leave the bond market and look to buy stocks, the number of shares available to those investors will be less and prices will go higher.

Action - If stocks are going higher, which I think they are, where should an investor put their money? Markets do not go straight up, there is always an ebb and flow to the various market directions. The S&P 500 is up over 9% in the first quarter of 2013, that pace will not continue. Stock prices could fall back, remain stagnant at this level or go up a little more, I do not know. What I do believe is that over the next several years, stocks are going higher and I also believe the stocks that will have the best returns are large dividend paying companies. I am not saying this because I am a dividend growth investor, I am saying this because the demographics of the stock investing public is getting older and most older investors think safety first. As investors leave the bond market, when rates start to rise, they will look for safe dividend paying companies to invest in, they will not be looking for start-ups or the newest hot technology stock. The large baby-boomer generation is either in retirement or approaching retirement, that generation of Americans have been through several market upheavals and will be looking for safety above all else. That will lead them to the large dividend paying companies.

As an investor, you should look for companies that dominate their business, preferably have little competition, have a strong balance sheet able to withstand economic turmoil, have a sustainable product that will still be in demand 10 or 20 years from now and that pays a dividend that is growing. Once you identify the companies that fit that description, put together a watch list with those companies on it and determine what a fair price to pay for them is. Companies that fit the above description, seldom go on sale, but you can get them at a fair price.

In the past when I have written articles concerning companies that fit the above description, I have discussed the companies I own, Exxon Mobil (XOM), the world's largest publicly-traded integrated oil company, McDonald's (MCD), the world's largest restaurant chain, Coca-Cola (KO), the world's largest beverage company, Walgreen (WAG), the world's largest pharmacy/health and wellness store, and Kinder Morgan (NYSE:KMP), the largest pipeline company in the United States. However, for this article I thought I would mention two other companies that fit the above description, I do not own them, but they are on my watch list.

UPS (NYSE:UPS) - Ten or even 20 years from now I am sure there will be a need for UPS. International trade is growing and shipping of items from country to country is becoming common, these trends will continue as more international citizens enter middle class. Competition is somewhat reduced as there are only three major international shipping/logistics companies in the world, with UPS being the biggest. UPS pays a healthy 2.9% dividend and has been buying back shares; in 2012 UPS bought back 3.4 million shares. With its strong free cash flow of approximately $5 billion a year, dividends and shares buybacks will continue. It has industry leading margins and strong capital efficiency. UPS information here.

If you look at the dominant business positions UPS has, the strong cash flow, the necessity of the business and the opportunity for future growth, it is clear that at the right price, UPS can be bought and held for years.

Johnson & Johnson (NYSE:JNJ) - As the world population ages and healthcare needs grow, Johnson & Johnson will continue to provide the pharmaceuticals and healthcare supplies the world population needs. In 2012, JNJ had sales of $25.4 billion in pharmaceuticals, $27.4 billion in medical devices and $14.4 billion in consumer products. JNJ has a AAA credit rating, has increased its dividend for 50 straight years and has had 29 straight years of adjusted earnings increase.

There is little doubt that healthcare will be a growing need for decades to come, with aging populations in much of the world. JNJ with its strong balance sheet and diversified supply of products will be a major player in the healthcare field for years to come. If some area of healthcare grows that JNJ is not involved in, the company has the financial muscle to acquire a leading company in that field. At the right price, JNJ is a suitable holding for any investor with a long-term view of investing. In my opinion, JNJ has had a nice run and may be a little ahead of itself here. However, on any pullback, JNJ is a good long-term buy. JNJ information here.

Summary - An investor can always find reasons to be bullish or bearish on the market. When I started my research I had no real inclination one way or another. However, the more indicators I looked at, the more I saw a real underlying strength to the economy and corporations, a strength I do not believe is fully priced in to stock prices.

Where stock prices will be next week or next month- I do not know. But I do believe a year from now and two years from now prices will be higher. The majority of American corporations are in the best financial strength they have been in years. They have strengthened their balance sheets and shared ever increasing cash with shareholders. The American economy is slowly recovering from the damage that occurred during the recession and shows signs of further improvement.

While the American economy improves and American corporations pile up the cash, other areas of the world struggle with economic issues that will not be solved quickly. No other area of the world has an economy that is improving, corporation that are financially strong and a low cost diverse energy supply. I firmly believe these advantages will lead to stock market strength and will once again make the United States the envy of the world.

Disclosure: I am long XOM, MCD, KO, WAG, KMI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.