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The Next Bubble Is About To Kick Off

And it's stocks. 5 points on how stocks could double from here:

A) Gold and Bond flows will get reallocated to stocks (think 1980, when gold was last at alltime highs). Bonds at 3% interest rates can't compete with growing companies with a free cash flow yield of 9%.

B) M&A activity. About $443 billion worth of M&A transactions were announced in the first 9 months of 2010 versus about $325 billion in the first 9 months of 2009. M&A is through the roof and we have another $2 trillion (the cash Corporate America has in the bank) to go (just today, NZ gets bought by IBM for $1.7 billion and INET, a company with $4.6 million in earnings Q2, is getting bought for $640 million by a private equity firm).

When CEOs are using cash to buy companies instead of stock it shows they are comfortable with their prospects going into 2011 as well as the accretive prospects of the companies they are acquiring.

C) Stock buybacks are on a straight line up ($267 billion announced so far this year versus $125 billion for all of 2009 (and $52 billion at the same time last year).

Latest news on buybacks:

  • Microsoft is issuing debt to do stock buybacks
  • Alliance Data announced a $400 million share buyback.
  • Hewlett Packard expanded its debt and also expended to $10bb its share buyback program.

D) Companies are increasing dividends at a rate of 180 companies (increasing) to 2 (decreasing) in the S&P 500. Even Cisco just began its dividend.

E) Earnings will probably come in at $100 per share in the S&P 500 next year. According to the Fed Model we can even justify a 25 P/E ratio here. (I'm not saying we will have a 25 P/E ratio but there's a lot of space between here and there)

The stock market is ruled by supply and demand. The supply is the number of shares outstanding. The demand is largely composed of the inflows into mutual funds. Supply is shrinking.

Ultimately there will be between $300-400 billion worth of buybacks this year plus another $50-100 billion of M&A, potentially removing $400-500 billion worth of stock on the stock market. The market value of the S&P 500 is approximately $3 trillion.

The market is roughly flat on the year right now largely because of the outflows from mutual funds. Eventually, that will change, like it always does. Mutual fund assets under management for equities has reverted back to 2002 levels. When people are tired of making 0% on their bond funds the money will flow back into stocks which are trading at a historically high free cash flow yield of 9%.

This is the biggest arbitrage on the market in history.

What can derail it?

  • Excessive business regulation breeds uncertainty, which is directly related to why Chinese stocks that are public here trade for 5-8x times earnings. Increased regulation will decrease the P/E ratio of the market.
  • Tax increases (or not extending the Bush tax cuts) will temporarily create irrational selling that could cause unvirtuous cycle. Every hedge fund manager out there has to determine their tax risk on long-term holdings in December. The last time hedge fund managers had forced irrational selling (in 2008, due to mass redemptions), the stock market crashed for six months.
  • Deflation. But the Fed, under Bernanke, will use a printing press to ensure that doesn't happen (in a worst case scenario). Note that deflation can be caused by #1 and #2 above.

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