Why Wall Street Might Spur a Bull Market in 2011

|
Includes: DIA, QQQ, SPY
by: John Tobey, CFA

In Wall Street, it’s New Year’s Day. Wall Streeters are back, refreshed from their summer vacations, wearing starched white shirts and ready to focus on what 2011 has in store.

As they assemble their teams, the question is what their conclusions will be. This is the second hurdle I described in “This Stock Market Decline Is Painful” on July 2. (Also see July 27 article, “US Stocks Clearing Their First Hurdle.”)

Wall Street is looking good

Interestingly, just about all the Wall Street players have reasons to be enthusiastic, and optimism (like pessimism) can spread among them. Within the news reports are many positive signals – e.g., see The Wall Street Journal for last Friday, September 3 (just ignore the “but” clauses and “modest” modifiers by remembering that most reporters are trend followers, not leaders).

Here are the Wall Street developments that could bloom into full-fledged trends:

  • Investment bankers are seeing a burgeoning corporate interest in strategic mergers and acquisitions, backed by large cash reservoirs to make the deals happen
  • Private equity fund managers, armed with access to cash and borrowings, are looking at many companies that have stabilized or are starting to grow yet still have low-priced stock
  • Venture capitalists are experiencing a rebirth of the IPO (initial public offering) market that typically leads to greater investor willingness to buy such issues. (A lengthy out-of-favor stock market can experience a good IPO market when general stock interest returns. The reason is that the good companies in the venture capital portfolios continued to grow, becoming ever more desirable as potential IPOs.)
  • Institutional investors appear to be gaining confidence in those 2011 earnings forecasts. If so, they likely will decide that waiting for a second dip or whatever is too risky a strategy. (Remember that they are in a highly competitive world where playing it “safe” at the wrong time can lead to lost investor-clients, bonuses and even jobs.) In the face of the potential 2011 earnings growth (currently estimated at about 15%), stock prices could easily (and quickly) rise from today’s value-laden, low levels. Therefore, the decision could be that it is “time to do a little buying.”

Could investors catch Wall Street’s US stock enthusiasm?

To answer that question, we need to focus on those institutional investors. Any pickup in US stock demand could cause the excellent values available today to disappear speedily. Why? Because there is so much money available for stock investment, and there are so many investors that are significantly underweighted in US stocks.

In addition, there are two engines that could increase demand further:

(1) Cash flow into US stock mutual funds becomes positive – After the lengthy outflow period (see graphs, below), a reversal would be especially noteworthy, and many investors prefer to swim with the current, not against it

(2) US stock performance improves – Good returns always pique investors’ interest

Finally, we have a unique and powerful catalyst: The mainstream alternatives (bonds, CDs and the like) have abnormally low yields. They have reached the point where their popularity depends on investors’ fear of US stocks. Get rid of that roadblock and any investor will begin to think that the current dividend yields look pretty good, even excluding the other potential returns (increased dividends, capital gains and capital gains taxation). Like the institutional investor, the conclusion could be it’s “time to do a little buying.”

So… that’s the situation today. How Wall Street reacts to 2011’s outlook will determine whether or not we’re on the verge of a US stock bull market. Importantly, it won’t take much optimism. A slight, positive shift could cause a strong, new trend to take hold – and quickly.

Here are the updated mutual fund inflow/outflow graphs:









Disclosure: No positions