The three most important factors that drive the stock market turned bullish on balance in July and remain so now. The strategic investment implication is that investors should set their portfolio allocations to common stocks to their maximum comfort levels.
The tactical investment implication is that investors should consider market declines to be “corrections” or “buying opportunities.”
The three factors that drive the stock market include two that are fundamental in nature and one that is technical. The first measures changes in interest rates like the 10-year T-Note, federal funds and others. Most interest rates have been falling and the implication has been bullish since April. The second compares the interest yield on BAA corporate bonds to the earnings yield on the S&P 500 Common Stock Index. Based on that comparison, the stock market became unattractive in June 2008 and remains so now. The third factor – momentum – turned bullish in July for the first time since October 2007.
Majority rules here: whenever any two factors are bullish, the stock market has outperformed its historical return, usually for an extended period. The signal from these three factors has changed just once a year on average since 1965 and bullish periods have tended to last more than a year.
Evidence that economic recovery has started continues to accumulate. Industrial commodities prices have risen since December 2008 and unemployment insurance claims have declined sharply since last March. This fits with the view that the major economic problem was the severe “shock” associated with Lehman Brothers failure in September 2008. Based on past shocks (Nixon’s resignation in 1974, Carter’s threat to impose credit controls in 1980, Iraq’s Kuwait invasion in 1990), the economic freefall should have been expected to end within six to nine months.
Based on commodities and claims, the freefall almost certainly ended last March and the recovery probably started last June. Quite a few economic indicators, like the ISM Manufacturing Purchasing Managers’ Index, have traced a V-shaped rebound.
Despite such evidence, doubts that an economic recovery has started – or that it could persist and be robust – remain widespread, due in the main to reports that the employment level has continued to fall and that the unemployment rate has continued to rise. But it is not unusual for the unemployment rate to peak after recessions have ended. And it is normal for the stock market to rise before recoveries take hold and the unemployment rate falls. Investors who wait to raise allocations to common stocks until after the unemployment rate has dropped always miss sharp rebounds in stock prices.
The stock market has rebounded but it still looks quite cheap from a broad historical perspective. This is based on how the interest yield on BAA corporate bonds compares to the “cyclically adjusted” (10-year trailing average) earnings yield on the S&P 500 Common Stock Index. Based on this relationship, which can be traced back to 1924, the stock market was more undervalued last winter than ever before and clearly discounted the worst. Whenever such low-valuation extremes were reached in the past, the stock market tended to rise sharply over the next three to five years.
The very positively sloped yield curve has been telling us to expect an economic recovery and expansion. Rising commodities prices and falling unemployment claims confirm that an upturn has started. Interest rates will rise in 2009 but not cause a recession or bear market anytime soon. The stock market discounts trouble and is vulnerable to positive surprises. Washington’s policies threaten to undercut secular trends but that can be reversed. Cyclical prospects are much better than feared.