Jim Paulsen: Here are 8 reasons to still love this bull market

Published Tue, May 23 20173:31 PM EDT

Jim Paulsen, Investment strategist

After an unexpected post-election rally carried the U.S. stock market to new record highs, stock prices have trended sideways in the last three months. Is the recent peak in the stock market suggesting a correction is nearing? Perhaps even a bear market? As is usually the case, there are good reasons to be cautious. After all, this bull market is already one of the longest on record, valuations are stretched, volatility has been uncommonly low suggesting investor complacency, U.S. real GDP growth slowed significantly in the first quarter, and the Federal Reserve has raised the Fed funds rate twice since December, threatens more hikes yet this year and is about to begin to shrink its balance sheet. For these reasons, some near-term turbulence in the stock market would certainly not be shocking. However, rather than suggesting increased investor caution is warranted, we believe the trendless stock market of the last few months is underscored by several factors combining to refresh this rally. As shown in chart 1, both the U.S. Dollar Index and the 10-Year U.S. Treasury yield have risen significantly since last summer. By last year-end, the 10-year yield had increased by about 1.25 percent in the previous six months, moderating future forecasts for economic and earnings growth and challenging the relative valuation of the stock market. Moreover, the U.S. Dollar had jumped by 10 percent from last summer to its highest level in almost 15 years. Dollar strength typically reduces U.S. multinational competitiveness, intensifies top-line pricing pressures particularly among commodity producers, lowers global sales expectations and reduces overall U.S. economic growth forecasts. In short, by early this year, higher yields and a rising U.S. dollar were becoming problematic for the stock market. Fortunately, as shown in chart 1, both bond yields and the U.S. dollar have recently pulled back easing the pressure on the stock market. After almost a 2-year hiatus, as illustrated in charts 2 and 3, U.S. company fundamentals (both sales and earnings growth) have been refreshed. A rare synchronized bounce in global economic activity, a significant recovery in commodity prices helping boost materials and manufacturing results, solid bank lending growth and rising interest rates reviving the financial sector and some improvement in overall profit margins have all contributed to this fundamental revival. Nothing is perhaps more convincing that this bull market is not yet over than a solid restart of the earnings cycle! Many have recently focused on low VIX volatility readings as proof that investors have become too bullish. However, in our view, a trendless stock market for much of this year, a significant slowing in U.S. economic reports in the first quarter, widespread disappointment in the lack of successful policy results from the new administration, increasing concern about high valuations and worries surrounding the Fed as it finally begins to normalize monetary policy have kept investor sentiment relatively cautious. Chart 4 shows bears outnumber bulls by about 10 percent in recent weeks among individual investors. While bullishness may have risen briefly during the post-election rally, it has faded in recent months. In addition, defensive sectors have done better recently (e.g., consumer staples and utilities) while most cyclical sectors have lagged (i.e., small cap stocks, industrials, financials and materials). Finally, despite recent record highs in the U.S. stock market, domestic equity fund flows remain lethargic relative to strong bond fund flows. In our view, rather than being overly giddy, investor sentiment probably has room to improve. Many believed the post-election surge in the stock market was due to expectations of forthcoming government policy changes which would prove favorable for the financial markets. The "Trump Bump", therefore, was widely perceived as a risk for the stock market should policy changes not occur as fast as most anticipated. Currently, though, optimism surrounding the Trump administration has evaporated and few expect any near-term positive policy outcomes. Indeed, many now fear the administration has become a quagmire. For much of this year, investors feared the "Trump Bump" would unravel. Now, however, with expectations dashed, perhaps Trump could become a positive surprise for the financial markets. The stock market is sensitive to economic surprises. Indeed, the surge in the U.S. economic surprise index (chart 5) beginning last Fall coincided with a strong rally in the S & P 500 . The Trump Bump probably had less to do with the stock market run than did a significant improvement in U.S. economic momentum. Likewise, the stock market has struggled in recent months as positive U.S. economic surprises have waned and actually turned negative. As economic reports have turned disappointing, expectations for future growth have declined. This increases the possibility U.S. economic surprises could again turn positive later this year (i.e., the economic surprise index in chart 5 could rise again back above zero) and provide a foundation for yet another leg higher in the stock market. As shown by charts 6, 7 and 8, economic momentum outside the U.S. remains healthy despite U.S. economic surprises turning negative. Throughout this recovery, the U.S. has been considered the only engine of sustained growth. Typically, when U.S. momentum slowed, conditions in the rest of the world got even worse. Is this is finally changing? Can the U.S. economy experience a period of economic weakness without the rest of the world collapsing? Is this why the U.S. stock market has remained near record highs even though U.S. economic surprises have turned negative? Sustainable "global growth" (even if it is slower than historic norms) is a new phenomenon in this recovery. If it is for real, not only could it help diminish downside risk in the U.S. stock market but could also provide a foundation for additional rallies. Chart 9 provides a proxy for how investors view "good news" on the economy. Typically, when the correlation between changes in the stock market and bond yields is positive, investors are more concerned about the potential for weak economic growth and/or deflation risk. Consequently, good news on the economy (i.e., reports of stronger real growth or accelerating inflation) while it may raise interest rates, is still considered good news for the stock market. When investors are in this mindset, they view any good news on the economy as reducing deflation risk. Conversely, a negative correlation between stock prices and bond yields reflects investors which are mostly concerned about inflation/overheating risk. In this case, good news for the economy is bad news for the stock market. Since 1999, the correlation in chart nine has turned negative three times. Each time, the stock market suffered either a bear market (in 2000 and again in 2008) or a correction (i.e., the negative correlation in 2014 was followed by almost three 10 percent corrections within the following two years). Currently, since the correlation is positive, investors can expect that any recovery in U.S. economic momentum will most likely be met by a stronger stock market. That is, "good news" on the economy, even if it results in higher interest rates, is still (for investors still primarily worried about deflation and weak growth) "good news" for stocks. The Federal Reserve has raised the funds rate three times since late 2015 and two times since last December. Moreover, the Fed is threatening to increase the funds rate further yet this year and seems poised to soon begin restricting liquidity by contracting its balance sheet. Normally, such actions would be proving quite challenging for the stock market. Of course, today, there is very little about monetary policy which is normal and the recent and projected actions of the Fed may be hard to notice for a while. Chart 11 shows that although the Fed has lifted the funds rate three times already, the real funds rate has barely increased, is still less than zero and remains about as low as at any time in recent years. That is, in real terms, the funds rate does not appear restrictive. Moreover, while the Fed may soon start to reduce liquidity, as chart 12 suggest, they have a long way to go before anyone really notices. Bottom line? Because of the oddity of this monetary cycle, investors probably risk turning cautious far too prematurely based on early Fed tightening actions. In this cycle, it may take much more than the traditional "three steps and stumble" before the economy and the stock market even realize that the Fed has tightened. Stock market valuations are certainly above average, but they are not excessive. Chart 13 illustrates the price-earnings (PE) multiple for the S & P 500 index based on historic trend line earnings per share. Trend line earnings are derived from a regression of actual earnings against time since 1950. Trend earnings smooth out the cyclical fluctuations and bases the PE multiple on the secular trend level of earnings. Since 1950, S & P 500 earnings have oscillated regularly about the trend line and current trend line earnings (at about $119) are nearly equal with current trailing S & P 500 earnings. The current trend line PE multiple is about 20 times and is above the historical average of slightly more than 16 times. No doubt, stock market valuations are high today. But does this imply the stock market is at imminent risk or could it remain highly priced for some time? As shown in chart 13, PE multiples often stay high for many years. For example, the stock market frequently traded above average during a 15-year period between 1955 and 1970. Similarly, the stock market traded at extremely high PE multiples (often more than 20 times earnings) for much of the last 25 years. Indeed, compared to the last quarter century, the latest PE multiple is only slightly above average trading today at the 56th percentile for all months since the early 1990s! Overall, valuation risk is elevated today but this does not mean the bull market is over. Provided the economy avoids recession in the next few years (as we think likely), it would not be uncommon for the PE multiple of the stock market to simply trend sideways at its current elevated level allowing the bull market to continue at the pace of earnings growth. There is certainly risk evident in today's stock market. The bull market and the economic recovery are no spring chickens, valuations are extended and for investors the Fed is turning from friend to foe. However, our guess is the S & P 500 index will likely rally higher yet this year (perhaps even reaching as high as 2600 sometime yet this year?). The trendless stock market of recent months has been refreshing this rally. It has lessened a couple major hurdles, checked investor sentiment, eliminated Trump Bump optimism and reduced U.S. economic growth expectations (which could now be pleasantly surprised). Moreover, after almost a two-year pause, the earnings cycle has recently been restarted, global economic momentum remains broad-based, healthy and synchronized (a rare event in this recovery particularly in the face of the recent slowdown in U.S. growth), good news is still good news for investors (i.e., the stock market may continue to rise even if yields also rise), Fed tightening may prove underwhelming for some time and finally, although valuations are extended, they do not suggest an imminent bull market end. We would remain over-weighted to stocks focusing primarily on international markets (both ex-US developed and emerging stocks), small and mid-capitalization stocks and the more cyclical sectors of the stock market including materials, energy, industrials, financials and technology. Paulsen, the former chief investment strategist for Wells Capital Management, has spent more than three decades on Wall Street. This note was republished with his permission.

Jim Paulsen

Adam Jeffery | CNBC

For these reasons, some near-term turbulence in the stock market would certainly not be shocking. However, rather than suggesting increased investor caution is warranted, we believe the trendless stock market of the last few months is underscored by several factors combining to refresh this rally.