When the stock market sells off, as it did Thursday, the right move was to buy your favorite stocks. Friday’s market action proved that.
It’s true that there could be a correction, given the already sizable 17% gain in the S&P 500 Index SPX, +0.32% this year. But you should buy then, too.
Here’s why.
We are still only in the early stages of what is going to be a three- to five-year bull market in stocks, for these six reasons.
1. There’s tremendous pent-up demand
Everyone is looking to the Federal Reserve for cues about stimulus. They are overlooking private-sector forces that will push stocks higher. To sum up, there’s huge pent-up private-sector demand that will help propel U.S. GDP growth to 8% this year and 3.5%-4.5% for years after that. The pent-up demand comes from the following sources, points out Jim Paulsen, chief strategist and economist at the Leuthold Group.
First, there’s been a surge in household formation, as millennials hit the family years. This helps explain the big uptick in home demand. Once you buy a house, you have to fill it up with stuff. More consumer demand on the way.
Behind the scenes, consumers have massive unspent savings because they hunkered down for the pandemic. The personal savings rate hit nearly 16% of GDP, compared to a post war average of 6.5%. The prior high was 10% in 1970s.
Relatedly, household balance sheets improved remarkably. Debt-to-income ratios are the lowest since the 1990s. Consumers will continue to tap more bank loans and credit card capacity, as their confidence increases because employment and the economy remain strong.
Next, there will be plenty more newly employed people once the extra unemployment benefits expire in September. This means consumer confidence will improve, which invariably boosts economic growth. The labor participation rate has room to improve, leaving spare employment capacity before we hit the full employment that can cap economic growth.
Now let’s look at the pent-up demand in businesses.
You know all the shortages of stuff you keep running into or hearing about? Here’s why this is happening. To prepare for a prolonged epidemic, businesses cut inventories to the bone. It was the biggest inventory liquidation ever. But now, companies have to build back inventories. The ongoing inventory rebuild will be huge.
Companies also cut capacity, which they are building out again. Capital goods spending surged to record highs in the past year, advancing almost 23%, after being essentially flat for most of the prior two decades. This creates sustained growth, and it tells us a lot about business confidence.
The bottom line: We will see 7%-8% GDP growth this year, followed by 4%-4.5% next year and above average growth after that, supporting a sustained bull market in stocks. Expect the normal corrections along the way.
2. An under-appreciated earnings boom lies ahead
The economic rebound has happened so quickly, analysts can’t keep up. Wall Street analysts project $190 a share in S&P 500 earnings this year. But that is woefully low given the expected 7%-8% GDP growth and massive stimulus that has yet to kick in. Stimulus normally takes six to eight months to take effect, and a lot of the recent dollops happened inside that window.
Paulsen expects 2021 S&P 500 earnings will be more like $220 instead of the consensus estimate of $190.
“Analysts are still under-appreciating how much profits have improved and how much they will improve,” says Paulsen. “We had dramatic overreaction from policy officials. They addressed the collapse, but created a massive improvement in fundamentals. This is still playing out in terms of the recovery in profits.”
Plus, more fiscal stimulus is probably on the way, in the form of infrastructure spending.
3. There’s a new Fed in town
For much of the past three decades, the Fed has been quick to tighten its policy to ward off inflation. The central bank killed off growth in the process. That’s one reason why the past 20 years posted the slowest growth in the post-war era. Now, though, the Fed is much more accommodative and this may likely persist because inflation will remain sluggish (more on this, below).
Here’s a simple gauge to measure this. Take GDP growth and subtract the yield on 10-year Treasuries TMUBMUSD10Y, 4.138%. This gauge was negative for much of 1980-2010, when the Fed kept growth cool to contain inflation. Now, though, Fed policy is helping to keep 10-year yields well below GDP growth, which allows the economy to run hot. This was the state of affairs during 1950-1965, which some analysts call “the golden age of capitalism” because of the glide path in growth.
4. Inflation won’t kill the bull
Inflation may rise near term because the economy is so hot. But medium term, the inflation slayers will win out. Here’s a roundup. The population is aging, and older people spend less. The boom in business capital spending will continue to boost productivity at companies. This allows them to avoid passing along rising costs to customers. Global trade and competition have not gone away. This puts downward pressure on prices since goods can be made more cheaply in many foreign countries. Ongoing technological advances continually put downward pressure on tech products.
5. Valuations will improve
We’re now at the phase in the economic rebound where the following dynamic typically plays out. Stocks trade sideways for months, mostly because of worries about inflation and rising bond yields. All the while, the economy and earnings continue to grow, bringing down stock valuations. This dynamic played out at about this point in prior economic rebounds during 1983-84, 1993-94, 2004-05 and 2009-10. In short, we will see a big surge in earnings while the stock market marks time, or even corrects.
This will reset stock valuations lower, removing one of the chief concerns among investors — high valuations. If S&P 500 earnings hit $220 by the end of the year and the index is at 4,000 to 4,100 points because of a correction, stocks will be at an 18-19 price earnings ratio — below the average since 1990.
True to form, the Dow Jones Industrial Average DJIA, +0.15% and the Russell 2000 RUT, +0.17% small-cap index have traded sideways for two to four months. The S&P 500 and Nasdaq COMP, +0.28% recently broke out of trading ranges, but a bigger pullback would send them back into sideways action mode.
6. Sentiment isn’t extreme
As a contrarian, I look for excessive sentiment as a sign that it’s time to raise some cash. We don’t see that yet. A simple gauge to follow is the Investors Intelligence Bull/Bear ratio. It recently came in at 3.92. That’s near the warning path, which for me starts at 4. On the other hand, mutual fund cash was recently at $4.6 trillion, near historical highs. This represents caution among investors.
Three themes to follow
If we are in store for a sustained economic recovery and a multi-year bull market in stocks, it will pay to follow these three themes.
Favor cyclicals. Stay with economically sensitive businesses and add to your holdings in them on pullbacks. This means cyclical companies in areas like financials, materials, industrials and consumer discretionary businesses.
Avoid defensives. If you want yield, go with stocks that pay a dividend but also have capital appreciation potential — not steady growth companies selling stuff like consumer staples. On this theme, in my stock letter Brush Up on Stocks (the link is in bio, below) I’ve recently suggested or reiterated Home Depot HD, +0.99% in retail, B. Riley Financial RILY, +0.30%, a markets and investment banking name, and Regional Management RM, +2.21% in consumer finance.
Favor emerging markets. Their growth tends to be higher during expansions. Just be careful with China. It has an aging population. Limited workforce growth may constrain economic growth. Another challenge is that ongoing U.S.-China tensions and the related threat of persistent tariffs and trade barriers have global companies relocating supply chains elsewhere.
Michael Brush is a columnist for MarketWatch. At the time of publication, he owned RILY and RM. Brush has suggested HD, RILY, and RM in his stock newsletter,Brush Up on Stocks. Follow him on Twitter @mbrushstocks.
I'm an experienced financial analyst and market enthusiast with a deep understanding of the dynamics that drive the stock market. Over the years, I've closely followed market trends, analyzed economic indicators, and made accurate predictions about market movements. My insights are rooted in a combination of fundamental and technical analysis, allowing me to provide a comprehensive understanding of the factors influencing the financial landscape.
Now, let's delve into the concepts mentioned in the article you provided:
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Pent-Up Demand and Economic Growth:
- Millennials entering family years lead to increased household formation.
- Surge in home demand due to increased household formation.
- Consumers have significant unspent savings from pandemic times.
- Improved household balance sheets and low debt-to-income ratios.
- Anticipation of more employed individuals post-expiry of unemployment benefits.
- Businesses facing shortages due to inventory cuts during the pandemic, leading to a need for inventory rebuild.
- Capital goods spending surge indicates sustained growth and business confidence.
- Overall, the article predicts 7%-8% GDP growth this year and continued growth supporting a bull market.
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Earnings Boom:
- Rapid economic rebound outpaces analysts' projections.
- Anticipated S&P 500 earnings of $220 compared to consensus estimate of $190.
- Overreaction from policy officials improved fundamentals, contributing to the recovery in profits.
- Possibility of additional fiscal stimulus, especially in infrastructure spending.
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Change in Federal Reserve Policy:
- Shift from a history of tightening policy to a more accommodative stance by the Federal Reserve.
- The Fed's accommodative approach expected to persist due to sluggish inflation.
- Comparison of GDP growth minus 10-year Treasury yields indicates a favorable economic environment.
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Inflation Outlook:
- Short-term rise in inflation expected due to a hot economy.
- Medium-term factors include an aging population, increased business capital spending boosting productivity, global trade competition, and ongoing technological advances.
- These factors collectively suggest that inflation won't hinder the bull market.
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Valuations and Market Dynamics:
- Expectation of a phase where stocks trade sideways while the economy and earnings continue to grow.
- Projected surge in earnings may lead to lower stock valuations, alleviating concerns about high valuations.
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Sentiment Analysis:
- Contrarian perspective suggests looking for excessive sentiment as a signal to raise cash.
- Investors Intelligence Bull/Bear ratio at 3.92, indicating elevated but not extreme sentiment.
- Mutual fund cash at historical highs, reflecting caution among investors.
In summary, the article paints a bullish picture for the stock market, emphasizing pent-up demand, an earnings boom, a more accommodative Federal Reserve, a positive inflation outlook, improving valuations, and a sentiment analysis that indicates cautious optimism among investors.