Stocks' comeback is on track, but much needs to go right for bull market to break out

  • Stocks seem caught in a neutral zone, stretched neither to the upside nor downside based on its short-term trend.
  • Goldman Sachs points out the S&P is following the "typical" path coming out of a double-digit correction outside of an economic recession and this implies a possible return to the old highs in a couple of months, with further upside toward the 3,000 level on the S&P 500 later on.
  • Bond yields, FANG stocks and earnings growth surprises will determine whether this bull market can break out again.
Traders work on the floor of the New York Stock Exchange (NYSE) in New York.
Brendan McDermid | Reuters
Traders work on the floor of the New York Stock Exchange (NYSE) in New York.

Stocks have been moving sideways in the month since the market first burst off the lows of its first double-digit correction in two years.

In a typical pattern following a sharp gut check for investors, the major indexes have gyrated within a range, alternately feinting and surging.

As this Bespoke Investment Group chart of the S&P 500's technical condition from Friday shows, stocks seem caught in a neutral zone, stretched neither to the upside nor downside based on its short-term trend.

Source: Bespoke Investment Group

With the index coiling in a pattern of somewhat narrower daily ranges, it's likely the market tries to break one way or the other before long. So what is the new trading range for stocks? If the Feb. 9 intraday low of 2,532 on the S&P is presumed to be the floor for now — down some 8 percent from here — how high is the ceiling?

Goldman Sachs strategists point out the S&P is following the "typical" path coming out of a double-digit correction outside of a recession. The index is traveling along the channel made by averaging all such past episodes — and implies a possible return to the old highs in a couple of months, with further upside toward the 3,000 level (9 percent from here) on the S&P 500 later on.

Source: Goldman Sachs

The answer, as always, depends on the interplay of growing corporate earnings, the path of bond yields and investor risk appetites. While in January a rising tide of strong earnings-growth forecasts and loose financial conditions lifted all boats fast, investors now face opposing currents of good-to-mixed economic data and slightly less generous financial conditions.

The S&P 500 forward price/earnings multiple has eased back from 18.6 to 17.1 the past two months as the market came off the boil. Yet bond yields have been sticky just beneath their multiyear highs, with the 10-year Treasury hovering above 2.8 percent for weeks. This could restrain equity upside unless or until investors collectively come to accept a thinner valuation cushion under stocks compared with risk-free bonds. We will continue to undergo episodes where good economic news is taken badly by stocks because of what it means for the Fed and bonds, while perhaps also puzzling over the chance for a first-quarter lull and weak retail sales.

The inverse of the market's forward P/E is its "earnings yield," and many strategists and economists compare this to the 10-year Treasury to gauge the relative attractiveness of equities against government debt.

This so-called "equity risk premium" sits about where it did when the S&P first rose to current levels in mid-January — with higher profit forecasts since then directly offsetting the climb in bond yields. This really just measures risk appetite, so it's tough to predict. Note: For most of the prior two cycles, stocks didn't appear as attractive as now based on this gauge.

Source: Morgan Stanley

Morgan Stanley strategist Michael Wilson — among the Street's most bullish in 2017 — sees this dynamic capping the market this year even as he allows for a run to further record highs.

He thinks the S&P 500 can stretch to 3,000 in coming months on sturdy cyclical stocks and anticipated earnings growth above 15 percent over the next two quarters. Yet a marginally more assertive Fed and generally tighter financial conditions, Wilson says, should pull the S&P back toward 2,750 (just 2 points below Friday's close) by year's end.

Not to say the upside flourish in January represented an absolute "good-as-it-gets" moment for this market, but it won't be easy to improve much on the conditions prevailing at the time.

Markets rushed to price in a step-function pop in corporate earnings from a big tax cut. Also, risk spreads on corporate debt matched their lows for this cycle, and retail investors jumped headlong into equities as they hadn't in years.

The history of such "melt-up" phases suggest that when momentum peaks and they finally falter, volatility rises, the leadership of the market often narrows a bit. But the bull market tends not to be over and can carry higher at a less effortless pace.

Breaking through the ceiling

What would it take to lift the market's ceiling much beyond S&P 3,000?

  • Credit markets will have to pay the band to stay an extra hour to keep the equity party going. Heavy demand for riskier corporate credit has been a crucial support for stocks. Even if Treasury yields continue higher, a smaller premium demanded by credit investors for corporate debt would help lift equity valuations. There's limited room for all that much spread-tightening, but improvement from here is not so far-fetched, given talk of demand outstripping supply of corporate debt as companies repatriate overseas cash.
  • FANG-type stocks could continue punching above their enormous weight in the indexes — just because. The Nasdaq 100 is up 11 percent year to date on a seemingly voracious investor appetite for world-dominating tech platforms. The Nasdaq 100 already trades at more than 22 times the coming year's earnings, a 25 percent premium to the broad market. Apple, Alphabet, Microsoft, Amazon and Facebook together make up 36 percent of the Nasdaq 100 and 15 percent of the S&P 500. If we get toward another late-'90s-style tech mania, who's to say the NDX couldn't trade up to, say, 25 times earnings?
  • Time: As Wilson notes, even as earnings growth slows into 2019, they will still be projected to grow, so the denominator of the forward P/E can push higher and eventually support a higher ceiling.

For sure, much would have to go right for the index to hold or improve much on those levels — none of it a sure thing, but all of it at least plausible.