A new term has been coined by market analysts to describe how many investors are feeling about the markets right now - “nervous bulls”. Normally, when the market is free falling, we hear the adage, "don’t fight the tape", meaning take your money and run while you still have it, but rarely do we hear this clamor when the market is going up. Sure, there are reasons to worry; the bear case goes something like this: further deterioration in home prices, increases in foreclosures and the lock up in the credit markets will pinch consumers who will slam the breaks on the economy. Short and sweet, but there may be a bull case that is even more compelling.
To begin, we should take a look at the wealth effect, taking note that there is very little data that correlates a drop in housing prices with consumer spending. This is largely because data on falling housing prices has been hard to come by, with consistent nominal gains over much of the last 70 years. So let’s take a look at some numbers on which there have been correlations established. The wealth effect also includes consumers’ reaction to stock market prices. Year-to-date the S&P 500 is up 9.82%, which follows strong years since 2003, a net positive. Other factors affecting the wealth effect: wage growth, 4.1% year over year; consumer borrowing, up 6% year over year; unemployment 4.7%, although it recently ticked up, it is still very low by historical standards, all net positives.
Now let’s take a look at the interest rate cycle. I have written extensively in the past about probabilities of upward markets six months and twelve months out once the rate easing cycle started; both periods are favorable. Two factors that may influence this relationship are PE expansion and Capex cycles. Going back to 1980, every rate easing cycle has led to PE multiple expansion. Given that we are starting from a PE of 14.6X on forward years earnings on the S&P500, which is relatively low over recent historical standards, it is reasonable to believe there is room for multiple expansion. There is also a high correlation between Capex cycles and Fed rate cycles that indicates an upward inflection point in Capex near the beginning of the Fed rate easing cycle. This is especially interesting because it potentially may give investors a reason to think corporate spending may pick up should consumer spending ease due to housing weakness. But most importantly, let’s not forget that based on valuation, stocks are still the best valued asset class compared to bonds, real estate or commodities.
Okay, but couldn’t the Fed act as the spoiler if it halts it interest cutting bias? The Fed’s mandate is to balance price stability with economic growth. The bursting of the housing bubble means lower asset prices, which correlates with a slow down in economic activity which in turn reduces pricing power which has a disinflationary effect. Meaning, at least for the short-term, deflation may be a greater cause of concern. I know this can be hard to stomach given the spike in commodity prices we have seen recently, but one should keep in mind that the Fed interest rate policy is meant to work as a tool on aggregate supply and demand; commodity prices are largely being influenced by factors that may lay outside the definitions of aggregate supply and demand.
Finally let’s not forget Q3 earnings since they will be in the spot light over the next few weeks. Thomson First Call currently estimates Q3 earnings growth to be approximately 3% for the S&P500. This, of course, is the weakest number we have had since the latest stage of the bull market began. The whisper number is between 6% and 8%, which could provide further room to rally.
None of this is to say that a severe downturn in housing can’t derail the bull party, but the point is, there are real reasons to be bullish and not fight this tape.