11/19/14

The S&P 500 is now more than 200% higher than at its crisis-induced 2009 lows. But despite the powerful recovery in stocks, the rally has had few believers. All along the way, skeptics have pointed to threats in Europe, domestic debt issues, political stalemates, perceived asset bubbles — you name it. As it relates to stocks, they’ve all been dead wrong.

The truth is, global central banks are in control; they have been since coordinating in 2009 to save the worldwide economy from an apocalyptic spiral. And because the crisis was global, and the structural problems remain highly intertwined globally, the only hope toward achieving a return to sustainable growth is through continued coordination. The Federal Reserve has led the way on this front and continues to do so, now through forward guidance rather than outright quantitative easing.

How does this relate directly to the stock market? Simple: The Fed needs stocks to be higher. The Fed needs housing to be higher. Fed officials get their desired wealth effect through higher stocks. And from pinning mortgage rates at historical lows, they get wealth gains from rising housing prices.

The Fed can’t manufacture a sustainable recovery through monetary policy, but it can influence confidence. Members can assure the public that they stand ready to suppress any “shock risk” that might derail stock prices. And they, along with other major central banks, have proven they can do it. So with the elimination of a negative event that could tumble the stock market, why wouldn’t you own stocks? The Fed wants you to, and they are giving you no better alternative, with a 2.4% 10-year Treasury yield.

Still, there are plenty of naysayers that like to throw around words like bubble. They like to say the stock market is just a house of cards and that it’s completely manipulated by the Fed.

The truth is, the Fed does manipulate interest rates. That’s what they do. They set rates as a tool in an attempt to achieve their mandate of price stability and full employment. Stocks tend to be a byproduct of interest rate policy.

If core inflation runs hot, the Fed raises interest rates to curb it. When that happens, in normal times, stocks tend to soften. But these aren’t normal times. Core inflation is still under the Fed’s target of 2%. In the latest Fed minutes released Wednesday, officials noted inflation could stay low “for quite some time.”

Europe is fighting deflationary pressures, and so is Japan. So the Fed has no reason to raise rates. And even when they finally do, they are moving off of ZERO. When they move rates higher from such emergency, record-shattering low levels, it will not have the same effect as a normal rate-hiking cycle typically intended to cool down a hot economy. When they raise rates this time, it will be a celebration, as it will mean the economy and credit demand are both strong enough to deal with an increase in interest rates.

With this in mind, the economy, for the first time in a long time, will likely grow by about 3% into the end of this year and for next year. That means we have the underpinning for healthy earnings growth for stocks for the first time in a long time. And earnings growth drives stock prices.

For those who argue the economy is fragile, the bond market disagrees with you. The yield curve may be the best predictor of recessions historically. Yield curve inversions (where short rates move above longer-term rates) have preceded each of the last seven recessions. Based on this analysis, the below chart from the Cleveland Fed shows the current recession risk at 3.42% — virtually nil.

Given that central banks remain in control, rates are still exceptionally low and recession risk is nearly nil, any recent dip has been a huge buy opportunity. Still, several years into an economic recovery, fear continues to creep in for investors when there is any downtick in stocks. Perhaps it’s a form of post-traumatic stress disorder or simply a lack of perspective, but people seemingly have been conditioned to think another big crash is coming, despite the lack of evidence. The reality is, the U.S. economy is in a very different place than it was in 2008, and so is the global economy. Even if trouble were brewing, much of what might be an unknown in normal times is well-known now. We know how the central banks and governments will respond.

We’ve had seven declines of close to 5% or more in the S&P 500 since late 2012. In each case, the decline was fully recovered in less than two months. In most cases, the decline was recovered inside of one month. This is an amazing fact, yet many people have been focused on trying to pick a top rather than preparing to buy the dip.

You may have noticed I referenced the period from late 2012, in which stocks have been particularly resilient. This is not arbitrary. It coincides with the date Japan first telegraphed the massive policy effort to defeat deflation. The BOJ has since more than doubled its balance sheet, devalued the yen by nearly a third (vs. the U.S. dollar) and pushed up Japanese stocks by more than 100%. The massive BOJ experiment is a recipe for higher U.S. stocks. It pumps new money into the global economy and creates capital flows out of Japan and into U.S. stocks.

The above evidence supports the case for a continued rise in stocks. How high can they go?

If we applied the long-run annualized return for stocks (8%) to the pre-crisis highs of 1,576 on the S&P 500, we get 2,917 by the end of next year, when the Fed is expected to start a slow process toward normalizing rates. That’s 45% higher than current levels. Below you can see the table of the S&P 500, projecting this “normal” growth rate to stocks.

In addition to the above, consider this: The P/E on next year’s S&P 500 earnings estimate is just 16.8, in line with the long-term average (16). But we are not just in a low-interest-rate environment, we are in the mother of all low-interest-rate environments (ZERO). With that, when the 10-year yield runs on the low side, historically, the P/E on the S&P 500 runs closer to 20, if not north of it. A P/E at 20 on next year’s earnings consensus estimate from Wall Street would put the S&P 500 at 2,600.

Bryan Rich
Co-founder, BillionairesPortfolio.com