Why U.S. Stocks Can Move Higher in 2007 - Part I

It is our conclusion that stocks can move much higher during 2007. This is no surprise to regular readers of "A Dash," but it is a good time to summarize the current situation. We will do this in a multi-part series examining several issues.

This installment considers an overview of basic considerations.

Psychology and Sentiment
Over the last few weeks we have noted a changed attitude among many active traders and fund managers who state public positions. We started to note these, planning to cite links, but decided against it. It is so pervasive that it seems unnecessary. Everyone is "taking something off the table" and trying to lock in gains, nervous about the seemingly relentless advance.

The TickerSense blogger sentiment poll captures this quite well, with over 40% bears and 25% neutral. It seems unusual for bearishness to be rising with the market.

One reason is that the bullish forecasters are seeing the market approach their original expectations for the year. Revisions to forecasts are modest. Abby Joseph Cohen is going to 1600 on the S&P for 2007. That puts her on the bullish extreme, but it is only about 6%. Ed Keon, whom we have cited in the past for his excellent analysis of market factors, remains the biggest bull with his forecast going to 1650.

Meanwhile, there are plenty of forecasts of a major blow for stocks. Traders are reacting to perceived risk and reward. That is how psychology works.

There is a lot of rhetoric about a "melt-up" or "ignoring the fundamentals." Since we believe in analysis rather than rhetoric, it is necessary to look at technical and fundamental considerations.

Technical Indicators
Before accepting the "melt-up" talk, it is useful to look at a chart. We recommend today's excellent analysis by TraderMike. We see in his charts some strong trending markets, but nothing parabolic. Many active traders follow Worden, where today's indicators show uptrends in every time frame they follow (subscription required).

Some technicians report "overbought" conditions. It would take a very small pull back to relieve these overbought readings. Moreover, overbought trending markets can move higher -- much higher.

Most importantly, our own technical models, devised by Vince Castelli, caught the end of last year and the current move. They remain bullish on all of the major indices, a position that (unlike many others) we have reported contemporaneously on TickerSense.

Fundamentals
Some assert that the market has gotten ahead of fundamentals, since stocks have advanced more than recent earnings growth. These analysts are focused on what we call "local efficiency." They are assuming that last year's pricing was an accurate valuation.

In fact, stocks have lagged during a multi-year period where profits grew at double-digit rates.

There is a lot of catching up to do.

Our own preview of 2007 informed investors that market valuations were low when one took the current low interest rates into consideration. Those who ignore interest rates in their analysis of fundamentals are adopting a method that we find distinctly inferior.

We have explained why this is true. Articles in this series will show how it is playing out before our eyes.

Summary
There are also plenty of miscellaneous arguments lacking evidence. Our favorite radio commentators on Car Talk have a term for such claims concerning car repairs. They call them "BOGUSSSSS." We will try to identify and discuss several instances including the following:

• "Peak" earnings
• Ignoring interest rates
• The market record of umpteen up days and the need for balance
• Stock buybacks as "inferior" earnings
• Poor recession forecasting
• Earnings mean reversion

Our work is laid out and our position is clear. Obviously, the stock market can decline at any time for many different reasons. Our technical models can change our trading positions, and we shall report if that happens.

These would be short-term factors. Our fundamental conclusion is that stocks have plenty of room to run. We remain leveraged up in trading accounts and close to full investment in individual accounts.

Comments

[MDCigan]

Interesting article, and certainly food for thought. In your summary section, you list some "bogusss" arguments without refuting them. Simply listing them doesn't make them invalid. FWIW, I think I know who you are taking a shot at with some of those (peak earnings and earnings mean reversion). Suffice it to say, I've found the arguments for those particular items compelling and supported by the historical data.

I think somewhere else you made the point that a good model has to be both descriptive and prescriptive. Otherwise, what's the point? Far too many strategists offer opinions based on notions/models that may have zero support in the historical data. One thing I think is important to note is to distinguish the ***TIME FRAME*** of the model.

You say "It is our conclusion that stocks can move much higher during 2007." It is a COMPLETELY DIFFERENT FORECAST to say what stocks may do over a 1-year time frame versus what the likely 5-10 year returns might be. If you carefully read the research which uses the concepts of peak earnings, earnings mean reversion, peak P/E ratios, you will note the conclusions refer to the probable 5-10 year returns and not what the market may or may not do in a single year.

Just use 1998-present as an example. There have been a couple of really good years, 1998,1999, 2003, 2006. Yet the cumulative return over the entire time frame for the S&P 500 has been pretty poor. One was better off in T-bills. I am somewhat skeptical of models that try to forecast 1-year returns for the market. From year to year, the market probably trades more on technicals and sentiment then anything else, and fundamental valuation asserts itself over long time frames such as 5-10 years (voting machine in the short-term and weighing machine in the long-term). 2007 may very well be a strong up-year for the S&P 500 with the cumulative 5-10 year forward return being mediocre to poor.

"Some assert that the market has gotten ahead of fundamentals, since stocks have advanced more than recent earnings growth. These analysts are focused on what we call "local efficiency." They are assuming that last year's pricing was an accurate valuation.

In fact, stocks have lagged during a multi-year period where profits grew at double-digit rates.

There is a lot of catching up to do."

This is certainly possible, but it seems to me what could just as easily argue that stocks began this multi-year profit run at more expensive valuation levels then at previous troughs in the business cycle and therefore it is no surprise stock prices have lagged profit growth. Perhaps, there is not catching up to do, but just further multiple contraction. Exactly what time frame is it that the stock market gains should exactly match profit growth?

"Our own preview of 2007 informed investors that market valuations were low when one took the current low interest rates into consideration. Those who ignore interest rates in their analysis of fundamentals are adopting a method that we find distinctly inferior."

I struggle with this one myself. I think strong theoretical arguments can be made both ways for including and ignoring interest rates. The question has to be asked though why didn't low interest rates matter in the 40s, 50s, or much of the 60s in terms of higher P/E ratios. What data from what time period are you going to include in building your model? And if you are going to ignore certain time periods, then why? And where to do you draw the line? 10 years, 20 years, 50 years, 100 years?

I look forward to any additional articles from you. I am not dogmatic, or a perma-bear, and would love to see a persuasive case supported by the data to be very bullish over the next 5-10 years and not just for a single year. But I think you are going to have to carefully examine and refute some of the arguments you list as bogusss.

[Jeff]

MD --

Thanks for your thoughtful observations. As you note, I have set up an agenda of questions to answer, and I appreciate your open-minded attitude.

It is always difficult for someone actively engaged in managing funds to write at the same time, but I intend to pursue the agenda. Stay tuned as I follow the concepts which I believe are dangerous for the average investor.

For the moment, let's just consider this idea. Either stocks were really overpriced in 2002, even after the bubble-bursting decline, or they are underpriced now. The balance sheets and earnings of corporations have improved dramatically, while the stock prices have lagged.

That is the basic idea. Future posts will show that this idea is recognized by big money, so the individual can get on board sooner or later.

Thanks again for your thoughtful ideas and questions.

Jeff

[MDCigan]

Jeff,

Thanks for your response. You say, "For the moment, let's just consider this idea. Either stocks were really overpriced in 2002, even after the bubble-bursting decline, or they are underpriced now."

This is an interesting point, and I think a useful way to view the question. Let's go with this. From the S&P 500 peak in 2000 to the trough in 2002, there was a decline of approximately 50%. Now, I think the gut level reaction would be of course stocks weren't overpriced in 2002. But maybe not so fast.

I'll go out on a limb here, and assume you would agree the 2000 peak level truly was an outrageous bubble valuation. Off the top of my head, I think the S&P 500 peaked at around 30-32x earnings. That was substantially higher than any other previous market peak. Off the top of my head, I think the 1929 peak was around 20x earnings and the 1972 peak was also around 20x earnings. Now let's compare the magnitude of the subsequent bear markets. The 1929-1932 bear market was an 85% decline I think while the 1973-1974 bear market was a 50% decline. So the 2000-2002 bear market was much less than the 1929-1932 drop and equal to the 1973-1974 drop despite starting from a valuation level almost 50% higher. Perhaps the 2002 trough didn't leave the S&P 500 underpriced at all, but at a valuation level that already anticipated and discounted a future profit recovery?

I completely agree with your point that future earnings are more important then trailing earnings in valuation. But the problem is we don't know future earnings, but we do know trailing earnings. And at least historically over the very long-term we know earnings for the overall market grows at around 6-7% a year when you look at the overall business cycle and not just the expansion part. If the S&P 500 can grow earnings at 10%+ for another 5 years, then absolutely it is undervalued here. But that is the million dollar question! And after the magnitude of the earnings growth over the past 5 years, there is absolutely no historical precedent for another 5 years of 10%+. At least historically earnings growth reverts. Maybe this time is different. Globalization, outsourcing labor, etc. But if the S&P 500 only grows earnings at 2-5% CAGR over the next 5 years, this market is substantially overvalued.

Geoff Gannon has written a bunch of very interesting articles posted here on valuation. Here is one link:

usmarket.seekingalpha....