Saturday, March 22, 2014

The Outlook For Stocks And Bonds: Still Bullish

Let’s begin with the meta-phenomena: money and credit growth. At present, both are quite weak. Money is growing at 6% which is too slow, given the current rates of inflation and nominal growth. Credit growth, which was contracting for a long time after the crash, has finally turned positive at an anemic 3.5%. Household credit growth has turned the corner and is now growing at 1%, which doesn’t cut it, while business credit growth is doing well at 8.5%. Federal credit growth--which sustained the economy during the recession--has now declined to 6.5%, which is still supportive. The weak link is household credit, which reflects the wounded housing market. The picture is therefore one of positive but weak money and credit growth.

Next, the outlook for bonds. Bond yields have risen sharply since 2012 (from 1.5% to 2.8%), despite a decline in inflation from 2% to 1.1%. The bond market appears to have mistakenly assumed that QE would accelerate money growth, which it has not. Money growth has been steadily declining since QE3 was announced in September 2012. I see no reason for bond yields to rise any further, and I think that yields are vulnerable to negative shocks, such as weak employment or nominal growth. Consequently, I am bullish on bonds, which translates into being bullish on stocks.

Stocks are no longer the screaming buys that they were when the Dow was at 11,000 in October, 2011. The equity risk premium has declined as prices have risen by 45% since then. But stocks are still more rewarding than the alternative asset classes: bonds, cash, metals. Stocks still have an attractive forward earnings yield (6.3% on the S&P), which compares favorably to bonds (2.8%), cash (0%), and metals (0%). As corporate earnings continue to grow (in the single-digits) and bond yields decline, the equity risk premium should widen, making equities a bit more attractive. The Fed is still paying investors to hold stocks and penalizing them for holding cash, bonds or metals.

I don’t expect robust earnings growth this year, given 4% nominal growth. But I do expect some EPS growth, especially for those companies using free cash flow to shrink their float. While topline growth may be slow, overall profitability is high, which leaves plenty of room for return of capital to shareholders.

When the Dow was at 13,000 in December 2012, I said that it would go to 15,000 by yearend; in fact it overshot my forecast and went to 16,000. For 2014, I expect the Dow to close the year about a thousand points above where it is today. That would be in the range of 17,000 to 17,500.

I see nothing coming out of the Fed in the near-term that would change this calculus. Although Yellen is a dove, there is no evidence that she plans to shake things up. Like Bernanke, she will seek consensus and do nothing radical. Money growth, inflation and nominal growth will remain subdued. The real funds rate will remain higher than it should be. Nonetheless, the business cycle is on the upswing.

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