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5 Economic Keys Driving Stocks To New Highs

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September 29, 2012 - 5 Economic Keys Driving Stocks to New Highs - By Zacks Investment Research

Since the May correction, the market has scaled a big wall of worry that kept many investors on the sidelines and put lots of bears in the trading ICU.

Central bank words from both sides of the Atlantic helped propel the S&P 500 from 1300 to 1400 in June through August. And then central bank actions and short-covering launched us to 1,475 in mid-September.

But last week, I made the technical case for new highs this year because the charts said big investors must actually like the fundamentals too - not just unlimited QE.

Now that the first significant pullback since July is in progress, it's time to look at the five fundamental drivers that will motivate money managers to buy the dips.

1) Europe on the Mend

Europe is definitely in a recession and no doubt will remain so for all of next year. But the heavy lifting required to backstop their sovereign debt crisis is finally occurring. Against the wishes of the old guard inflation hawks of Germany's Bundesbank, the ECB is slowly evolving to become a lender of last resort.

When Mario Draghi took office one year ago, he ridiculed those who suggested this was the destiny of Europe's central bank. But he and more moderate members of the ECB have recognized that the "irreversibility" of the euro is paramount and they will now do whatever it takes to save their grand experiment.

2) US Economic Resiliency

The big mistake that big investors made in 2010 and 2011 was in believing that an economy approaching stall speed was one headed toward recession. But after two years of sending stocks into steep corrections near 20%, they finally realized that corporate earnings were still growing despite a slew of problems:

• 1% GDP

• Debt-ceiling debacle

• Euro meltdown

• China slowdown

• 8% unemployment

What's the fundamental case for a US economy that can continue to see corporate earnings grow? Some themes are very persistent, and some are just being realized:

• Record low interest rates and corporate cash, which make stocks the place to be

• Housing bottoming and brewing with animal spirits, which predicts job creation

• While 45% of S&P profits come from abroad, the impact of Euro-China has been small and the worst was priced-in at S&P 1,300

• S&P earnings estimates for 2013 are slowly inching down from above $110 toward $105, and that makes S&P 1,450 trade under 14X. Still very attractive!

• Energy sector is in a "sweet spot" feedback loop where booming domestic exploration and production raises supply, keeps prices stable and creates jobs

• US innovation creates the future - and tomorrow's profits - from technology, biotech and high-tech manufacturing industries to financials, retailing and energy

3) Fiscal Cliff Navigable

What are the chances that Congress comes together and works out the tax and spending compromises necessary to reduce the deficit but not derail the economy? That's a scary question to even think about. Some of the worst estimates are a 5% blow to GDP if all the tax cuts expire and all the automatic spending cuts go into effect.

In May, I also thought this brick of uncertainty in the wall of worry was too heavy and unpredictable to ignore. But the market began shaking it off this summer, almost as if investors could imagine the worst impact and then begin seeing all the ways it could be avoided. Either that, or they are waiting for more visibility on the election before the "fiscal cliff" hand-wringing returns.

Though we are seeing some impact on business spending and confidence in the second half of this year, this is not affecting investors who are discounting fundamentals out into the first half of next year. I think the market has got this right and that our Congress men and women will not jeopardize the economy again for political gain.

4) China Not So Bad

We've been hearing it for a year now. When Chicken Little and the Boy Who Cried Wolf aren't crying about Europe or US manufacturing, they are wailing about the hard-landing in our biggest trading partner. There's some substance to their complaints, with Caterpillar and FedEx feeling the global slowdown and rumors of Chinese economic stimulus coming this year being sorely over-exaggerated.

But the truth is that China has engineered a soft landing. It's still in progress because they are still concerned about over-heated property markets. And a big stimulus package seems inevitable for a country with hundreds of millions of citizens migrating to new cities for jobs and housing.

China cannot afford to slip much below 7% growth and word is that this package is on the runway, ready for take-off. What are they waiting for? The new regime to take office and hit the launch button with a chunk of their $3 trillion plus in foreign exchange reserves.

5) Central Banks All-In

Finally, we have to talk a little about QE. I started this piece suggesting that part of the summer rally was fueled by expectations for central bank actions on both sides of the pond. And you may have noticed that these did not unfold into "sell the news" events.

Why? Because market players needed to know that central banks were all-in on the war against deflation here and banking weakness over there. There was doubt over whether the Fed and the ECB could both overcome political entanglements and criticism to win the long-term economic war.

The most important banks in the world have spoken and acted. We can only hope their work has enough momentum to get some inflation cooking. The alternative is a Japan-style zombie economy.

Let's say that I am far too optimistic and wrong about each of these drivers to some degree. Guess what? Stocks can still go higher because Mr. Market still climbs walls of worry and will always fool the most investors.

And even if a bigger market top is building, we aren't there yet. S&P 1500, here we come.

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