Right now there is only 1 catalyst for US stocks: the European Debt Crisis.
Day after day our markets follow suit with theirs. That's because a disorderly exit for Greece or heightened problems in Spain or Italy would spread panic throughout the continent. This would most definitely send recessionary shockwaves around the world…including the good ol' US of A.
But There Is Hope.
There are solutions for the European problems. Some of which can be borrowed from the blueprints we used to emerge from the Great Recession. This has led to our three year recovery including a stock market that has doubled since March 2009.
If their politicians follow through on this, plus some form of banking union and/or fiscal union, then we can take the "Lehman-type" implosion off the table. As this happens the risk premium levied on the US markets will be lifted. This will allow investors to once again see the attractiveness of the US stock market.
Here are 5 reasons why European debt containment would lead to US stocks making new highs:
1) GDP is A-OK
Forget the horrible headlines about a soft jobs market. That is just the media playing on people's fears. The rate of jobs growth has been fairly stable the last two years and this is the 3rd time we have been at the low end of the jobs growth numbers just before we bounced. Most likely it will spike back up to 120-150K jobs added per month which is the recent norm.
When you look across all of the economic data it still points to an economy expanding at 1-2% per year. Yes, that is under long term historical trend of +2.7%. But it most certainly not a recession. This is the same Muddle Through growth pace we have seen the last couple of years which was good enough to lower the unemployment rate and generate record corporate earnings. More on that next.
2) Record Corporate Earnings
Too often conversations about the economy cloud people from what truly drives stock prices. That is corporate earnings. More specifically it is the growth of corporate earnings into the future that determines what investors are willing to pay for stocks now.
The current earnings estimates for the S&P stand at $104 per share. That is a record level which is set to go higher with a 2013 estimate of $117. And yet stocks are well off their record levels, which takes us to our next point…
3) Stocks Are Cheap
Given that analysts see no recession on the horizon they are still comfortable with their record earnings predictions for this year and next. Yet the S&P is only trading at PE of 12.8 current year estimates.
As we get towards the end of the year, more investors will be focused on 2013 estimates. By that scale the S&P is only trading at a paltry PE of 11.4 which is VERY attractive compared to the historical PE norms of 14-15. This paves the way for the next reason…
4) Stocks Best Investment Alternative
Most of the tricks up the Fed's sleeve to bolster the economy have been aimed at lowering bond rates. In fact, since 2008 they have been cut by over 60% with the 10 year note now yielding a historically low 1.7%.
This strategy makes holding bonds and cash very unattractive given their meager returns. Conversely it makes stock ownership VERY attractive as can clearly be seen with the earnings yield of 7.8%. (You get the earnings yield by flipping the PE on its head. Just divide the $106 in earnings expected for next year by the current S&P price level).
Traditionally the earnings yield for stocks is only 3% higher than the 10-yr Treasury rates. As you can see the spread is double that size now. This sets the table for our final reason…
5) Tons of Cash on the Sidelines
Survey after survey shows that the average individual investor has been scared out of the stock market given the precipitous drop after the Financial Crisis. Then toss in the tremendous volatility the past two years and you can understand why they've been saying "No Thanks!" to stocks for a while. But given human nature they won't stay away for long.
With cash and bonds so unattractive, gold going nowhere, and real estate still a risky bet, there will be a natural pull back towards stock ownership. As we float back up to recent highs of 1420, the media will start making a big deal about the stock market once again. The more this message gets out there, the more individual investors will feel they are missing out. As they pile back into stocks it will fuel the rally higher which will pull even more investors back into the market.
How High Can the Market Get?
Given the historical PE norms of 14-15 I shared above, we can easily make it to 1500 on the S&P without being overstretched. That might be in the cards by the end of 2012. And if the pendulum starts to swing away from fear and back to greed then taking on the all-time high of 1565 should be in the cards over the next 12-18 months.