The Road To October's New Highs

|
Includes: DIA, IWM, SPY
by: Kevin Flynn, CFA

You may well be wondering how I can possibly be saying such a thing, what with all of the danger spots on the radar. It may soon look even more wrong-headed, as September still has three trading days left, and the month often finishes in a bout of selling brought on by portfolio rebalancing. Given the returns in equities this year, it's hard to envision why it would be different this time around.

Let me add a qualifier -not unless Congress decides to phone in the stay of execution early this time, and we get a spending resolution over the weekend. History says that the denouement rates to happen late Monday night, but it also says that guessing governmental decisions is a mug's game.

Then there's the economy. The Fed just cut its outlook again, as it's been doing two or three times a year for several years now. The central bank is so impressed with the current economic torpor that it decided to postpone the taper that it surprised the world with back in May, the one that it got most investors to steady their balance on before pulling the rug out again ("we never promised one").

We're still trying to figure out how the Fed thinks it will ever de facto tighten without the market possibly noticing. Perhaps the governors are hoping to keep forward-guiding us until we finally lapse into a coma. My guess is that the unspoken flight square is the somewhere-over-the-rainbow return to prosperity, at which point the FOMC will go for the old tablecloth trick (my suggestion is that you not lend them your good China).

The Chicago Fed released its latest national activity index on Monday. I really think this picture is worth quite a few words, given the behavior of the top line (stocks) and the bars (the economy). The 3-month moving average is now negative for the sixth month in a row.


(Click to enlarge)

I don't think the weak index presages the end of the world, or that recession is necessarily imminent. The 3-month average did remain negative, but the latest month was mildly positive at +0.14. The moving average also put up a seven-month negative streak in 2012, after an eight-month such streak in 2011, yet it never got really close to the dreaded (-0.70) that the bank says is a recessionary warning light. It hasn't dipped below (-0.5) since October of 2009. The point isn't inevitable collapse, just that real 3% real growth isn't exactly in the cards either. The economy is simply not going anywhere while the stock market is going gangbusters. In the meantime, the recovery leg is getting long in the tooth. So is the bull market.

New-home sales are another example of what I mean. They're doing fine, going by today's report, and I expect them to continue to grow. But trees don't grow to the sky. Not in this chart, either:


(Click to enlarge)

The annual growth rate in new home sales (trailing 12-months) has been in double-digits for 16 months now. That's a decent recovery, and I happen to think it could last 24 months or so. But let's not ask too much. The previous decade's boom in housing managed a 22-month stretch of double-digit year-on-year gains (I slipped in two readings between 9.8% and 10%) before subsiding. The burst coming out of the 1982 recession was 18 months long, and in the 1970s we twice had stretches of about 2 years.

I'll say it can go even longer than 24 months this time too, if only because the annual tally is still so low and the crash that preceded it so massive. But let's be realistic. We don't have the huge demographic tailwind of the 1970s. We do have lower rates, but we also have much tighter credit, vanishingly small income growth, and newly-minted college graduates that already come with staggering debt loads.

Revisions to sales have been downward of late. The rate of gain has slowed a bit already, it will slow to single digits, probably by next spring, and once it does it usually levels off fairly quickly. That doesn't mean recession, but it does mean a growth motor that starts running in neutral, at least for a time. That's normal - the economic cycle hasn't been repealed. The Fed will lower its forecast again next year. Stocks rally.

Valuations aren't cheap, despite the usual sleights-of-hand dragged out to convince us otherwise. The Shiller P/E is at 24.2. Of course, it can go higher. We could all decide that owning stocks is a matter of life-or-death, and it could go to 50. That still wouldn't mean valuations were cheap, only that we were barking mad.

But look again at what's on the near future's radar screen, and you will find a goodly number of triggers for new highs, right there in the middle of the blinking red lights.

To begin with, a new spending resolution. I'm not predicting the outcome either way, but if we do get one Monday night, traders will wake up on the first day of the month with two reasons to party. Stocks rally. Maybe they shouldn't, but they will.

Then there's the debt ceiling. We're supposed to run out of money on October 17th. If the spending resolution goes through, the debt rhetoric will probably heat up again soon afterward. So we'll all settle in to watch Obama and the Chipmunks: The Squeakquel, and it rates to be the same scenario: showdown at high noon, with everyone promising to come packing heat - serious, nuclear heat - and then when the whistle blows, everybody has a drink and goes home instead. Stocks rally. I'm not saying that's what will happen - I refuse to bet on the random walk of policy decisions. But if it does, off we go. The New Year's Eve vote produced a 5% move in two days.

Somewhere in all of this, let's suppose that the President finally emerges with his nominee to succeed Ben Bernanke. After all, he really does need to get on with that soon. And let's suppose that the nominee is one Janet Yellen, whose doves coo even more sweetly than those of Mr. Ben. Guess what stocks do.

And somewhere else in all of this we're going to have an earnings season, one that will probably be another dull affair. The August-estimated earnings growth of 3.3% is now down to 1.2%, according to Zacks Research (in February, it was at 7.0%. What did you want to say again about that cheap forward earnings multiple?). That could finally drag stocks down from their new all-time highs, at least until the FOMC emerges from its Delphic cave on October 30th and tells us what the data now mean. And no, I'm not predicting that one either, but if the September jobs report is good on October 4th, right on the heels of a potential beginning-of-the-month rally, stocks could rally again. If it's mediocre, we could get another Goldilocks rally. If it's a dud, another no-taper rally.

You will have noticed by now the proclivity for modifying conclusions with, "stocks rally." That's in homage to the spring of 2007, when smart-alecky traders were passing around a list of yellow and red-light events, some of them only conjectured, that led every time to the same conclusion: "Stocks rally."

Are we back to that time yet? I don't know. I look at my long-term technicals, and they are worse than 2007, but not quite as bad as 1999. The Shiller ratio got up to a 27-handle in 2007, suggesting room for another 10%-15% of potential excess before the curtain drops. Short-term, the market is in a neutral position, apart from small-caps, which are overbought but not hugely so.

That leaves plenty of room for the zoom up to 1750 and beyond. All of this, of course, is completely sentiment-driven, fairly ridiculous, bordering on the irrational, and having very little if anything to do with the real economy. Any cold-blooded analysis would conclude that once the disaster-didn't-happen rallies are out of the way, we will be in danger of a serious correction. We probably are now as it is.

Stocks rally.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.