Despite Warnings, New Bull Market Leg Is Forming

by: John Tobey, CFA

Graph showing new leg upTypical of many warnings being proffered to investors these days, Michael Santoli (formerly at Barron's and now with Yahoo! Finance) has written Retail Investors Should Lower Expectations. He cites many reasons to be cautious and expect lower returns from "nearly all" asset classes. I've found Michael's writings to be well-done. However, I believe his latest article misses important points and puts overreliance on public investors' past timing mistakes.

His thesis (also supported by other market observers) is that, after over-cautiously missing out on the past 4+ years U.S. stock market run, investors now are blindly chasing stock performance as they run from plummeting bonds. However, he overlooks two important items that make this analysis wrong in today's markets.

First, bond investors didn't miss out. Rather, they earned good returns from bonds over those same 4+ years. Moreover, they avoided the extraordinary volatility in the stock market over those four years that tripped up many wannabe stock investors - especially those two major mega-fear periods in 2010 and 2011.

Moreover, the performance comparison is flawed. It assumes a stock investor bought on March 9, 2009, and that a bond investor sold stocks on the same date. Just because stocks climbed more since March 9, 2009, doesn't make those who held bonds the poorer investors. If the same bond vs. stock analysis is done for, say, the 7-year period that Santoli uses to look ahead from here, we see that the bond investor was clearly the wiser one: Comparable return and significantly lower volatility.

(Stock chart courtesy of

Second, the slow process of returning to normal has had the beneficial effect of carrying investors back in a relatively steady, calm manner. Pleasantly surprising has been the disproof of those terrible visions of permanent depression and despair. Instead, we now find that job growth, income growth, sales growth, earnings growth - even tax revenue growth - have become the trends. And, perhaps most surprising of all, because it produced the 2008-2009 mess, housing is growing again. All these growth trends have naturally produced a rise in confidence.

In the midst of the large move from bonds to stocks, Santoli asks, "What's a careful investor to do?" The answer is actually what investors already are doing: Rebuilding their portfolio with a good dose of stocks. Sure stocks aren't selling at 2009's panic prices, but so what? They're also not selling at high valuations driven by over-optimism. The acid test: 20 of the 30 Dow Jones Industrial Average (DJIA) stocks have dividend yields greater than the US Treasury's 10-year bond's 2.5% yield. Also, based on forward (next 12-months) earnings estimates, the 30 stocks sell at an average 7.9% earnings yield, equivalent to a 12.7 times P/E ratio. These measures are indicative of a market based on sensible investing, not wild-eyed speculation.

But, with growth slowing, won't stocks turn in weak returns?

No, for two reasons.

First, international sales growth will return

While growth has slipped in Europe and China, affecting world trade and U.S. exports, the causes have been exceptional. Europe and China have taken measures to correct adverse situations. As the corrections take hold, each will then shift policies back to foster economic activity and growth.

Europe -

Barron's cover article, Europe Will Bounce Back, included the EC's estimates of a return to positive, year-over-year growth as soon as the fourth quarter (+0.7%), with steadily increasing growth rates throughout 2014 (1.1%, 1.4%, 1.5% and 1.7%). And from the WSJ: Muddling Through May Work for Europe - "Critics underplay the scale of the adjustments that Europe has already achieved." In other words, we've likely seen the worst and better times are just around the corner.

China -

China's situation is uncharacteristic of any others we are familiar with because it's based on bubble prevention tactics. The government, wishing to put the country's growth on a sound footing and prevent bubble-induced speculation and its adverse results, has clamped down on the financial system. Because most developed countries shy away from taking such heavy-handed actions (instead, allowing the bubbles to grow and pop), China is an enigma to foreigners, like us. Barron's article, Smoke Signals from China, presents the challenge:

… China wants to see consumers spend more of their hard-earned cash [vs. borrowing] and its businesses reduce their reliance on easy money. Success could mean growth well below target.

Now, here is the capper - the misinterpretation of the situation:

That should worry investors…. The Asian giant accounts directly for some 5% of S&P 500 earnings…. Throw in China's massive influence on commodity prices, and the effect of a slower China could really be felt.

Think about it - Here is the largest developing country willing to put its current economy and financial system through a sluggish, challenging period to accomplish two worthwhile objectives. (1) Take smaller, manageable adverse consequences now rather having to deal with larger, hard-to-control ones later. (2) Build a more stable foundation for sound, long-term growth. That's a problem? Only to those who want fast returns.

So, when will China say, "Job well done," and allow the economy to grow again? With the news we are getting about the financial system's adjustments as well as the slowing growth rates (confirmed by those commodity price drops), the process is well underway.

For both Europe and China, a point to remember: Improvement is not defined as a return to normal. Just like our recovery from the Great Recession, improvements will be felt when the current situation begins to reverse. We don't need maximum growth to enjoy Europe's and China's positive influences.

Second, U.S. corporations' as-yet little used growth leverage: Pricing power

The Fed is once again allaying our fears of easy money by pointing to the continuing low inflation. However, the cause of relative price stability has little to do with the Fed's wise policies. Rather, the Great Recession's lengthy effect on two key price measures has provided the calmness: Housing and general service/product pricing. The Fed is about to lose the benefit from the first item as real estate prices, rents and mortgage rates rise - and fairly rapidly. And I believe the second force, corporate-induced price increases is upon us. The subject is getting discussed (e.g., see the WSJ article, How Companies Can Get Smart About Raising Prices) as the environment improves (i.e., the desire for cool and attractive begins to offset the need for cheap and functional). Disney (NYSE:DIS) recently broke the ice with its 5+% admission increase at its parks. Because the company is 100% dependent on discretionary spending (the first item to be cut from a consumer's budget), the company's decision is a good sign that pricing power is about to reassert itself.

The value of raising prices is high. First, the increases fall directly to the bottom line, benefiting shareholders (through earnings-based valuations and dividend increases) and incentive-based employees. Second, the increased cash allows companies to make growth and productivity investments, while keeping and attracting high quality employees.

The bottom line

Ignore the worriers about slowing growth. The two powerful forces that have helped do the slowing - Europe and China - are near to accomplishing their objectives. As their growth returns (and pent-up demand in those countries returns), we can expect those forecasts of ever-slowing growth to once again be wrong.

Likewise, ignore the thought that "dumb" investors have climbed back into the market's driver's seat, meaning stocks are bound to crash. Individual investors' mindsets are sensible and their return to stocks is financially wise. Overly heady expectations? There simply are no signs of them. For comparison, think about the over-enthusiasm for gold and Apple at their peaks. If anything, these widely followed boom/bust investments have produced vicarious, cautionary experiences for all investors.

Personally, I put any negative comments about the stock market in the "been there, done that" file and then forget about them. The stock market engine is turning over nicely, there's plenty of gas in the tank and the RPMs are well below redline. The road ahead? Unclear as always, but no signs of trouble. For that to occur, we'll need to see something amiss turn up - most likely from the stock market gaining too much speed.

Disclosure: I am long DIS. 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.

Additional disclosure: Positions held: Long U.S. stocks