Get Your Rally Shoes On Because This Rally's Got Legs

Herb Morgan (Efficient Market Advisors, LLC) submits: Stocks look to go higher, much higher. When you ask? Technically speaking (pun intended) the answer is now. Back on May 19th I penned “How to Identify a Market Top” for this space and on November 30th of 2005 I stuck my neck out with “Dow 15,000?”. I was pretty close to the top on energy and gold and it appears time will prove me right on stock prices.

Let’s look at valuations, fundamentals, and technical indicators. Today, we are presented with a relatively rare scenario where the planets are perfectly aligned.

Valuations: Stocks are cheaper than they have been in nearly 20 years

This chart measures S&P 500 fair value by comparing S&P 500 Price/Operating Earnings to the 10 Year Treasury Yield (See S&P 500 Index ETF (SPY)). Risk in equities remains low by historical valuation metrics.

Fundamentals: The scales are tipped in favor of equities

• Pre-Tax corporate profits increased $91.8 billion in the second quarter, down from the $142.3 billion increase in the first quarter, slowing the GDP annual growth rate to 2.9% from 5.6% in the first quarter. Rational Fed Governors will interpret this as a sign of the Goldilocksian nature of the economy.

• Corporate profits are at an all time high percentage of GDP as published by the St. Louis Federal Reserve Bank.

• September 1 Nonfarm Payroll data was positive and employment remains “full” at roughly 4.7%.

• Despite full employment, hourly earnings are experiencing no inflationary pressure.

• A slow orderly devaluation of a residential real estate market that had advanced beyond reasonable valuation is progressing nicely.

• Corporate Health is Strong

o Low default rate on corporate bonds.
o Low credit spreads on corporate bonds to treasuries indicates market confidence in repayment ability.
o Corporations have extended debt maturities and reduced total leverage thereby reducing the risk to equities.
o Cash holdings relative to assets have risen substantially as shown in the accompanying chart from the Federal Reserve. Large cash balances can be used to raise dividends, buy back stock, or invest for future growth. Large cash balances, on the margin reduce the risk of equity ownership.

o Second quarter earnings were strong and seemed to validate the theory that companies in general are shying away from giving overly optimistic guidance. This reduces the frequency of volatility inducing downward revisions.
o Tax receipts are up sharply for the US Treasury with the second quarter deficit coming in well below expectations. Federal Receipts are $1.97 Trillion through July of 2006 compared to total receipts of $2.1534 Trillion for all of fiscal 2005. (US Treasury fiscal year ends in September) Treasury receipts are on pace to be up 13% vs. fiscal 2005.
o Inflationary pressures are easing substantially as evidenced by recent price action in oil, gold, and bonds. This significantly reduces the likelihood of a Fed interest rate hike.
o For the past year stock valuations have remained low as the prospects for higher interest rates and inflation loomed. This is no longer the case and low interest rates are a reality which justifies higher stock prices.

Technicals: Stocks are quietly making noise

While it’s hardly headline news yet, stocks are advancing nicely. Today’s action helped bring the fifty day moving average of stock prices above the 100 day moving average confirming the uptrend that began in late July. (Source BigCharts) Get your rally shoes on!

At Efficient Market Advisors, we have made tactical shifts in our model portfolios to accommodate these views. The coming increase in demand for stocks will cause the valuation gap to decrease and if history is any guide, stocks may well become overvalued before this bull market peaks. Equities may stay over valued or under valued for extended periods of time. The bears today argue that the S&P 500 has returned 36.59% over the last 36 months and it just can’t continue, that the market must correct. Of course, all great bull markets had a 36 month number long before they printed a 72, 84, or 96 month number. Incidentally, the S&P 500 is down 5.08% for the last six years. We remain firmly bullish.

Comments

[WC Whiner]

In re DJI 15k, that's because 5% and 50% are practically the same, yeah?

I have made any number of embarrassingly wrong market calls, but I find it best to revisit them when wrong and identify whether I made ex-ante errors, or whether once again I simply fell prey to bad luck. Luck swamps skill every time. I might be happy to believe your index call last fall was simply bad luck, but I just can't respect the, "I shall be proven right in the end, just you wait," elision of events.

FD: like the folks at PIMCO, I see the housing slowdown taking down marginal consumption, hence marginal GDP, corporate profits and as soon as the market gets what's happening, the indexes. I am ready for my call to be wrong, but so far, the data are coming in much along that scenario. You won't want to be overweight US equities if I'm right.

[Daniel Houston]

hmmm...all these "fundamentals&quo... you point to have already happened. your pointing to them as reasons to buy stocks seems to contradict the efficient market hypothesis on which you base your firm's name.

your citing of all these economic variables seems meaningless unless you can show that each variable has, in the past, actually given managers an edge from which to build a trading strategy.

[hmorgan]

Excellent Comment Daniel. There is quite often confusion about the name of my firm. My belief in the Efficient Market Hypothesis relates to individual stock selection. (Hence the use of index based ETFs)
Having spent a long time in the actively managed world I make this statement from more than just academic theory. I do believe that Asset Allocation determines 94+% of a portfolios total return. For this reason we put the lion's share of our effort into the strategic and tactical elements of Asset Allocation, and hence the interest in fundamental data.

I hope that clarifies things. Again, thank you for your question.

Herb

[Daniel Houston]

thank you for your answer, Herb. good luck.