A 7% Rally In The S&P 500 Index?

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by: Clif Droke
Summary

JPMorgan predicts "shock and awe" rally, which many scoff at.

Both the technicals and fundamentals support this prediction, however.

Expect the 3,000 level in the SPX to be reached in coming months.

In a dull market environment, it’s not uncommon for those who make a living writing about stocks to resort to exaggeration. With the major averages basically treading water, it’s hard to resist the temptation to conjure up exciting scenarios for the broad market outlook. That appears to be the case for a high-profile price forecast made by a JPMorgan analyst this week. While the timing of this prediction may seem dubious, however, there’s no denying the possibility of it being fulfilled in the coming months. In today’s report, we’ll examine this prediction for a 7% rally in the S&P 500 Index (SPX) as we try to determine whether it has any merit. As I’ll argue here, the magnitude of the predicted rally could not only be realized, but exceeded, by this summer.

In a note to clients, a JPMorgan executive made headlines this week when he stated that a “shock and awe” equity market rally could potentially push the SPX to the 3,000 level. His bullish outlook is predicated on the Trump administration and the Federal Reserve working in concert to create a favorable condition for the supersized rally to take place. According to the investment bank’s executive director Adam Crisafulli:

The ‘shock and awe’ upside scenario involves rescinding all US-China tariffs instantly, causing certain tariff-sensitive firms to raise 2019 guidance, while the Fed commits to keeping reserves at ~$1.3T+. If all this were to come to pass, then the SPX will easily make a run towards 3K.”

While the term “shock and awe” will be dismissed by some as nothing more than a blatant attempt at grabbing attention, a rally to the SPX 3,000 level is nonetheless well within the realm of possibility in the coming months. Given how far the benchmark index has already climbed this year (11%), an additional 7% rally isn’t as absurd a proposition as it may seem. Viewed another way, the 3,000 level in the SPX is merely 200 points away from recent levels. With the SPX having rallied 100 points in February in what has been a remarkably low-volatility environment, the index could conceivably reach the 3,000 level in the next couple of months before even attracting mainstream attention.

S&P 500 Index

Source: BigCharts

The above statement shouldn’t be construed as a definite prediction. As a tape reader, I firmly believe in following the market’s lead and remaining bullish as long as the internal indicators support a rising trend in the SPX. Predicting upside objectives is largely anyone’s guess; what’s important is being on the correct side of the trend. In other words, if you’re in harmony with the market’s underlying bias, it really doesn’t matter how high the major averages travel. Only the market’s dominant intermediate-term (3-9 month) direction matters.

With that said, I tend to agree with Mr. Crisafulli’s bullish prediction for the SPX. Not only is his prediction supported by broad market internal strength, it’s also supported by fundamentals. Corporate balance sheets remain strong and earnings are still positive, even if the growth rate is slowing. For instance, despite the headwinds from an uncertain global trade outlook, the estimated earnings growth rate for Q4 2018 was 12.1%, according to FactSet. Also, 69% of S&P 500 companies have reported a positive earnings per share surprise in Q1 2019, according to FactSet, while 61% have reported a positive revenue surprise.

A word about the widely discussed corporate earnings slowdown is in order. Worries about an earnings recession in 2019 have dominated the financial media discourse recently and have given many investors pause for concern. And while the earnings growth rate on a year-over-year basis has slowed, there is still a compelling fundamental case to be made for remaining bullish on stocks. If we take as true Ed Yardeni’s observation that the stock market was never fully given credit for last year’s 25% earnings increase, then it can be surmised that the market has a fundamental basis for continuing to rally even as the earnings growth rate diminishes.

In other words, the current rally can be viewed, in part, as a reflection of the stellar long-term earnings growth rate. And while the first half of this year may indeed witness a slower growth rate, the SPX rally could just as easily be anticipating stronger earnings growth in the second half of this year.

Another factor which argues for the SPX making a charge at the 3,000 level in the coming months is the remarkable internal strength reflected in NYSE market breadth. The NYSE advance-decline (A-D) line is Wall Street’s favorite measure of breadth, and as you can see here the A-D line has roared to a new high after last year’s market debacle. The A-D line has historically acted as a leading indicator for the major averages, especially at critical intermediate-term turning points. That was certainly the case last September when the NYSE A-D line turned lower before the reversal in the SPX in October.

NYSE Advance-Decline Line Source: StockCharts

The rally to new highs in the A-D line is a testament to the broadness of the rally in the 11 S&P sectors. This should be an encouragement for the bulls and can be taken as a sign that the SPX will eventually follow the lead of the A-D line by making a new all-time high in the foreseeable future. It would certainly be unusual for the SPX to fail to achieve last year’s high in light of the strength reflected in NYSE market breadth.

An even bigger indication of just how much internal strength the 2-month-old market rally has is seen in the following graph. This chart depicts the NYSE new high/low ratio, which is one of my favorite measures of the incremental demand for equities. Note that this indicator has also recently made a new yearly high.

NySE New High/Low Ratio Source: StockCharts

When the number of stocks on the Big Board achieving new 52-week highs is growing relative to the new lows, it can only mean that the demand for stocks is strong enough to propel the major averages higher. This is especially true after a major decline like the one the SPX suffered just a few months ago. Small-time retail investors don’t typically line up to buy stocks after the market has crashed, so it can be assumed that the demand for stocks after a big decline is primarily from informed investors, or “smart money.” Thus, the incremental demand for equities reflected in the chart below is encouraging since it implies that the smart money sees good things ahead for the broad market.

In my previous commentary, I argued that a move above the SPX 2,800 level from here would likely exhaust the market’s remaining upside potential very quickly after setting off a major round of short covering. I consider that the market’s recent dullness is actually a good thing in that it will make an eventual upside blast-off move to the 3,000 level more achievable. A slow-but-steady grind higher is healthier for the intermediate-term rising trend since it allows the market’s recent overheated condition (caused by the 11% rally in just a few weeks) to cool off.

Ideally, there will be some additional sideways-to-slightly-lower movement in the SPX in the coming days to allow the index to gather strength before the next major rally commences. By this spring, I anticipate the market will be in excellent shape to begin the next phase of the recovery and then reach the 3,000 level in the SPX by summer.

On a strategic note, investors should be long the sectors and industries which are showing the most relative strength and solid fundamentals. In particular, investors should be looking at consumer staples, pharmaceuticals, and real estate equities, as well as the tech sector in general. I also recommended that technical traders maintain a long position in a market-tracking ETF, such as the Invesco S&P 500 Quality ETF (SPHQ), of which I’m currently long.

Disclosure: I am/we are long SPHQ, IAU, XLE, XLF. 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.