Will Stocks Soar to New Highs?

Want to follow up on my last comment, Take a Deep Breath and Exhale!, to go over why I remain optimistic that the US recovery will continue and that stocks will soar to new highs.

Every day we are bombarded with negative news on a number of topics: the euro debt crisis, China slowdown, the fiscal cliff, depression economics, Soros said this and Roubini said that.

I can't help but laugh at all the nonsense being fed to the masses and sometimes it's propagated by really intelligent people who should know better. I honestly couldn't care less about what some hedge fund manager or Wall Street strategist says on television. Show me your books and blow smoke elsewhere!

Investors must accept that markets are rigged and will remain rigged so that big banks and elite hedge funds can continue printing money while retail investors get screwed out of their life savings. In order to make money in these markets, you need patience and deep pockets because once a trend goes against you, it can really hurt your portfolio returns, especially if you need to cash out for retirement.

This is why I'm an ardent defender of well governed defined-benefit pensions. The sheep are getting slaughtered while financial sharks engaging in high-frequency trading, dark pools and naked short-selling are making off like bandits.

A couple of days ago I wrote a comment on why macro funds are experiencing difficulties in a world where central banks and unprecedented government intervention are squeezing spreads and making it harder to deliver outsized returns of the past.

A buddy of mine visiting from Greece shared this with me: "Good, it's about time governments squeeze these hedge funds spreading false rumors and playing with people's lives. Every time Soros or Roubini opened their mouths warning of an imminent collapse of Greece, bank runs shot up and so did crime. Meanwhile these guys are buying CDS trying to profit off countries' misfortunes."

I am not as cynical of hedge funds but agree with him that irresponsible comments and spreading malicious rumors made a bad situation a lot worse. The amount of pessimism out there is truly staggering, which is why I'm starting to be very bullish on stocks and other risk assets. Going forward, investors need to focus on sectors that got eviscerated over the past year.

ETF Daily News reports there are seven reasons to remain bullish on stocks:

1. Inflation is low. And it may well go lower. After all, oil and natural gas are sharply lower this year – and so are the prices of many other commodities. This will increase operating margins for manufacturers and purchasing power for consumers.
2. Interest rates are still zero. This is unfortunate for savers, but positive for consumers and businesses because it makes it so cheap to borrow. It also makes cash awfully unattractive relative to dividend-paying stocks.
3. Huge new markets are opening up overseas. Domestic consumption is rising in Asia, Latin America and Eastern Europe. And emerging markets make up three-quarters of the world’s landmass. They also make up roughly 85% of the global population. These folks are going to need everything we in the West take for granted: homes, cars, computers, cellphones, microwaves, dishwashers, credit cards, mortgages, health insurance and so on. This will be an engine of global growth for years to come.
4. Valuations are low. Even though the market has rallied, stocks are still cheap. The companies that make up the S&P 500 are selling for just 12 times earnings. That’s much cheaper than the historical average P/E of 16.
5. Equity funds are experiencing heavy net redemptions. It sounds counterintuitive, but it’s actually a positive thing when shareholders are cashing in their stock funds. Why? Because history shows the average fund investor has horrible instincts, piling into stocks when they are most expensive (as they were, for instance, during the internet bubble 12 years ago) and bailing out when they’re cheapest (as they were at the market bottom three and a half years ago). Take some consolation from the fact that they’ve been cashing out in droves this year.
6. Stocks yield more than bonds, a historical anomaly. In the first half of the twentieth century, if you had done nothing more than buy stocks when they yielded more than bonds and sold them when they yielded less, you would have timed the market perfectly. Unfortunately, this technique stopped working in 1958. That was the last time that stocks yielded more than bonds… until the past year. With bond yields at all-time lows, stocks now yield more. And if history is any guide, that makes now a good time to buy them.
7. Corporate profits are at all-time record levels. This surprises many investors, but it’s true. In fact, it’s been true for each of the past nine quarters. If you want to know why the stock market has kept pushing higher through all the gloom and doom, it’s because of this: Share prices follow earnings. And earnings – despite all the naysaying – have never been better.

Stock market investors have a strong tendency to think emotionally rather than rationally – and then regret it in the luxury of hindsight.

In the end, of course, markets make opinions, not analysts. So judge for yourself. Above is a three-and-a-half-year chart of the S&P 500. Does that look like a bear market to you?

From the reasons above, I'd say numbers 1, 3, 5, 6 and 7 are the key reasons why equities will climb higher despite all the negative news scaring everyone off.

But skeptics abound. Martin Barnes of BCA Research thinks we need to get used to a low return world, stating 2012 is not 1982:

Today, inflation can’t go lower, or we are flirting with deflation. And interest rates are unlikely to go much lower, as they are already as low as anyone thought possible. Profit margins, which were depressed in 1982, are currently at a secular high. He believes margins are likely to come down modestly from here. Finally, while the stock market is not expensive at a P/E of 14, it’s not super cheap either.

Three percent real return: Get used to it

Barnes called the bond market “a crazy, distorted market.” He believes we have to assume that we are eventually going to get back to a “more normal” world—which would involve higher interest rates. (If we do not make this assumption, Barnes fears for our personal sanity, pointing out the easy doomsday investment portfolio selections of cash and gold).

If rates do rise, this means in total return terms, government bonds are not going to do us any favors at all; he believes you can pencil in a zero for total returns. Barnes is more positive about corporate bonds, where he projects 6 percent returns per year over the next 5 years in, even allowing for some defaults.

His “middle of the road” scenario for developed stock markets is 6.5 percent nominal returns. It assumes the same market valuation as we have today, with 4 percent nominal GDP growth (with 2 percent real GDP growth and 2 percent inflation). So we have 5-6 percent returns with 2 percent inflation – or 3-4 percent real returns - which he points out is not bad, or depressing. The outsized returns in years’ past are the real outlier.

Relative value of developed sovereign bonds and equity markets

Barnes quantified the valuations of developed world sovereign debt and believes that on a relative basis the PIIGS debt is the cheapest—namely Greece, Italy and Spain. Seven percent yields are not sustainable in the long term, as they’d become insolvent. So if you believe the euro is staying together, these bonds are absolute buys today. (A big IF, he admits).

In applying the same analysis to developed stock markets, Japan and the U.K. are the cheapest, while the U.S. looks the most expensive (it’s outperformed and everyone loves it, he notes).

Given these low projected returns, and central banks throwing around money, should we look to alternative assets? Unfortunately most of these assets are not cheap, as it’s getting a bit late in the game. He sees few bargains in the commodity complex, for example.

There is one asset class that he believes is “extraordinarily cheap”: U.S. residential real estate. He doesn’t believe there is any developed country in the world with real estate as cheap. And mortgage rates are incredibly low.

His cheery summary on investment returns to come: “It’s a low return world and there’s not much that’s cheap out there, other than the stuff that scares you to death. Too bad.”

I used to work with Martin at BCA Research. He was a tough boss and had no qualms expressing his dissatisfaction if he thought your analysis was flimsy. Managing Editors used to dread having their work revised by him as it always came back with critical and often devastating comments.

But I know how Martin thinks, pretty much the same way he's always thought. He's a perennial cynic and skeptic. It was fun watching him go at it with other Managing Editors during our Friday afternoon meetings but learned early on to ignore his calls on equities.

I agree with some of Martin's comments above. We could be entering a long period of low returns analogous to the 1966 - 1982 era where stocks went sideways (including a violent bear market in 73-74). I think bonds are overstretched and yields will likely rise from these levels.

But unlike past episodes, we are still experiencing massive private deleveraging which will cap the rise in interest rates. Moreover, record hedge fund assets means you will see violent gyrations in risk assets on the downside and on the upside.

The other thing we have to remember is that the global economy is always evolving. Deep structural changes take years, often decades, to work themselves through the economic system. It's not all doom and gloom and while the past serves as a gauge, it's simply silly to think that all bull markets and bear markets have similar starting points.

Admittedly, I am a perennial optimist. It has a lot to do with my struggles with multiple sclerosis and life experiences. Have been very bearish in the past, and right on the money with my macro calls, but I prefer focusing on good news as the world is awash with pessimism and cynicism.

Right now I am bullish. There are plenty of opportunities in the stock market but tread carefully and know your risk tolerance. If it's low, stick to large caps that pay out healthy dividends (for example, AT&T which had a nice run over the past year).

I'm focusing my attention on sectors that got hit the most over the past year, including the much despised coal sector and other individual stocks like Nokia and Research in Motion which have been out of favor for so long (prefer Nokia). These are tough markets to read but pay attention to price action and ignore the noise (read my last comment for more ideas).

Below, highlights from Gabby Douglas' routines from the US Olympic team trials. The 16-year-old from Virginia won the women's gymnastics all-around gold medal and won the hearts of everyone with her beautiful smile and incredible skill. Amazing young lady who owes her success to two special moms.

And South Africa's Oscar Pistorius made history on Saturday when he became the first double amputee to compete in an athletics event at the Olympics. The 25-year-old qualified for the semi-finals of the 400 meters by running a season's best of 45.44 seconds in finishing second.

If you ever wanted to know the true meaning of the Olympics, look no further than these two gifted athletes. They truly represent the Olympic spirit and should be role models for all of us.