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Bullish potential

It's been three years now since the stock market peaked in the fall of 2007. During those three years, we've suffered terrible financial and emotional damage from a punishing bear market, watched our economy go through its steepest contraction (a decline of 4% in GDP) since the Great Depression, and been awakened to the fact that our financial system had been hollowed out and was/is in very shaky condition.

That's a lot to process and enough to turn even the most optimistic sorts into pessimists. But on top of that, we're watching a slow-motion government financial train wreck unfolding before our eyes. Huge deficits and debt are piling up with seemingly no willingness to recognize the extreme challenges about to hit our system in a decade or so (much of it in the form of increasing Social Security, Medicare, and health care obligations).

For three years now, many investors have been marinating in the toxic stew described above. Against that backdrop, how could anyone be bullish on stocks?

The key is recognizing that stock prices are not merely a reflection of current conditions. Rather they are a reflection of future expectations, and even more precisely, future expectations relative to current business valuations.

In other words, a change in expectations from "imminent Armageddon" to merely "terrible" can send the stock market soaring if stocks have been priced for the former. That's what we saw through 2009. And should the improvement go from "terrible" to "not so bad," that trend may have plenty of room to continue.

I'm not going to try to build a comprehensive bullish case in this post, but rather just relay some of the interesting bullish points I've noticed in recent weeks. I know it's hard to let this type of positive information in when many of us are still stuck in a reflexively defensive/pessimistic posture from the events and fears of the past few years. But for the first time in a while, it seems to me that the bullish case is looking pretty strong.

Let's look at some of these bullish factors. First, the market finally broke out of a four-month trading range last week by punching through the 1,130 level on the S&P 500. Many Wall Street watchers expected this trading range would be resolved when the market returned to business following Labor Day, and that appears to be happening.

From the March 2009 low of 666 to the April 2010 high of 1,217, the market rallied roughly 83%. It then fell 16% to a low of 1,022 on July 2. That correction was 35% of the prior move (a drop of 195 points — one-third of the prior gain of 551 points). That is a pretty textbook definition of a minor correction, although it certainly didn't feel that way at the time.

If we view this year's correction in terms of common, typical bull market behavior (rather than as the start of a new bear market), it's easier to look forward with more confidence as to what commonly transpires next.

What is that? As our October SMI newsletter piece on the election cycle and annual seasonality (subscribers' link) points out, we're nearly finished with what is typically the worst six-month stretch for stocks in each four-year presidential cycle. And we're on the cusp of beginning what is typically the best six months of that four-year cycle. Since 1950, the six-month period we're about to enter has averaged a gain of 21.8% for a portfolio split evenly between large and small stocks.

If that's not optimistic enough for you, the Stock Trader's Almanac reports that since 1914, the market has averaged a gain of 49.2% from the mid-term-election-year low to the high of the following year. (That's not the product of a few good years either — only four of those 24 instances saw advances of less than 32%.) If we assume the July low of 1,022 is indeed the low for 2010, that would imply a gain to 1,500 by sometime next year would be normal.

Hello? Do you hear anyone talking about a gain back to the levels of the 2007 peak by sometime next year? It sounds crazy, but a further gain of 32% from today's levels would merely be following the normal mid-term election pattern.

Sure, it's great to look at all these historical patterns and technical analysis mumbo jumbo. But is there anything in the fundamentals to support this kind of optimism? It turns out, there is.

The other day, I came across a great article by Jon Markman in which he points out that much of the "September surprise" in stock prices this year has been due to companies solidly beating earnings expectations. But more importantly, he references material from a British money management firm called Collins Stewart that makes a compelling case for stocks advancing strongly on the basis of their likely earnings and current valuations.

As we have noted several times in SMI, earnings estimates are often way too optimistic, thus we're skeptical of valuation methods relying heavily on those estimates. But Collins points out that following bear markets, it takes a while for analyst optimism to return, and in fact their estimates tend to be too low for the first three quarters of bull markets.

Based on the fact that Markman thinks analyst estimates will prove to be too low compared to how earnings come in (which has, in fact, been the case so far through this recovery), he thinks the market's current valuation (12 times expected 2011 earnings) is too low, not too high.

I encourage you to read his full argument, but the short version is that if the average P/E were to rise to just 15 on the back of stronger-than-anticipated company earnings, the market would likely move to around 1,440. (And he notes that when inflation and interest rates are as low as they are currently, P/E's typically wind up around 20, so 15 is hardly a stretch.)

Then he writes:

Before you scoff at this — and who could blame you — credit analysts say that bonds are already trading at levels that correlate with the S&P 500 topping 1,500.

So now we've got:

• multiple long-term historical trends,
• a fundamental earnings-based analysis, and
• the bond market

all telling us that it shouldn't surprise us to see the S&P 500 trading around 1,500 within the next year.

Okay, that's enough. I don't want to overstate the case. As I mentioned at the outset, there's still plenty of risk in this market. The possibility of a "worst case scenario" is still present, as the financial system remains fragile enough that an unexpected shock could still topple it. These bullish factors represent a shifting in the most likely outcome, but not an elimination of worst case scenarios. Risk has been reduced, but certainly not eliminated.

In recent years, the economy took some really tough punches, has been wobbling, but might not actually be knocked out. If that is the case, and we get back to something resembling "normal" again (ideally with our politicians straightening up their spending act) the stock market may have some catching up to do.

As we noted earlier, when the market is priced for a knockout and it doesn't happen, there's room for stock prices to advance. As businesses recover and the global economy (hopefully) continues to find its legs, investors could find themselves surprised by the sun starting to shine through the thick cloud cover they've been living under. It certainly wouldn't be the first time that has happened.

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