Why is the stock market continually hitting new highs, when “everyone knows” there are so many problems out there? From the geopolitical risk in Iraq and the Ukraine, to sluggish jobs and wage growth, and lumbering Fed debt that must be unwound?
It just might be that investors aren’t so stupid, after all.
It might be that the stock market, in hitting new highs, is playing its traditional role of leading economic indicator — signaling better economic growth ahead.
A word of caution is in order.
If Mr. Market is right, and the economy is poised for another leg up, it might not actually be straight up for stocks. Initially, news of an improved economy, probably sparked by a new capital spending cycle, could cause some panic about inflation and interest rates boiling over, and a more hawkish Fed.
This would hit both stocks and bonds. After that, though, the next leg up in the bull market will commence.
For the bull case for stocks over that time frame, I turn to insights from Goldman Sachs (GS) CEO Lloyd Blankfein and Wells Capital Management strategist James Paulsen.
The current problem:
“We are in a situation now where interest rates are hovering around zero and in some cases dipping below zero, and people somehow can’t find enough opportunity to take cash that’s offered to them at no cost and deploy it. Why is that?” asks Goldman Sachs CEO Blankfein.
Of course, Blankfein being Blankfein, he’s got an answer. “You are dealing with sentiment and people. (But) you can have a change in sentiment from one minute to the next. It not only changes your world view, it erases your memory of what you used to think,” says Blankfein.
Here’s how this might play out:
“Everybody is sitting on record levels of cash, and sitting and sitting,” says Blankfein. Then somebody does a deal, which gets the following chain of thought moving in the brains of CEOs, he says. “Yesterday I was thinking, ‘Boy it’s really risky if I do something. Now somebody else did something and got applauded. Hell, I’m a CEO I better do something, too.’” In other words, now it’s risky if they don’t do something.
Put another way, one of the biggest mistakes people make in forecasting is assuming complacently that things will just continue on as they are right now. “Sentiment can suddenly change,” says Blankfein. “Sentiment can shift, and when it does shift no one will remember that it was different a week earlier.”
Here’s who gets hurt:
“Interest rates are hovering at very low levels now. Does everybody know that eventually they are going to mean revert to a higher level? That interest rates are not going to stay just above zero once consensus reaches a conclusion that the economy is growing and demand for money increases? Nevertheless, will people suffer big losses and be shocked when interest rates go up? Yes,” says Blankfein, on PBS’ Charlie Rose show, June 9, 2014.
Blankfein isn’t the only one suggesting a big change in CEO sentiment could lie just around the corner — a change in sentiment which could move stocks a lot higher over the medium term.
In a note published late last week, Wells Capital Management strategist and economist James Paulsen suggests capital spending is poised to take off.
When it does, it could lift growth above 3%, and put a bid under stocks, especially tech stocks, which do well when capital spending gets unleashed.
It might just be coincidence, but the very strong performance of tech stocks I recently suggested supports this scenario. Six tech stocks I suggested to Brush Up on Stocks subscribers on May 8 and May 16, 2014, are up 35%, 15%, 12%, 11%, 10%, and 4% as of today, compared to gains of about 4% for the overall stock market during the same time.
Here’s are five reasons Paulsen cites to support his thesis that CEOs are about to open the capital spending spigot.
1) U.S. capacity is tightening.
Factory utilization is near 80% and job growth at a sustained 2%. Historically, those levels have been associated with an upturn in capital spending.
2) It may soon get too expensive to buy capacity.
The recent surge in mergers and acquisitions suggests companies may soon have to increase capital spending. Coming out of recessions, companies often first turn to upping dividends and share buybacks. Then they turn to M&A. We’ve gone through those two phases. Sooner or later, opportunities to buy capacity via M&A dries up, and it becomes cheaper to build capacity, says Paulsen. That might happen sooner than you think, he says. Read on, to understand why.
3) Global growth will support demand for U.S. goods.
Since the start of 2013, the global economies have synchronized into growth mode. Only about 5% of the world’s largest economies are contracting.
4) The weak dollar supports demand for U.S. goods, too.
The above trend of synchronized global growth, combined with dollar weakness on a trade weighted basis, suggests the U.S. trade deficit should improve. “The real value of ‘U.S. produce’ has been hovering near an all-time record low throughout this recovery,” says Paulsen. “So far, the U.S. has not benefited much.” That may soon change, he thinks, due to that improving global growth.
5) U.S. companies have the spending power.
We all know about that $2 trillion in cash on the balance sheet. But here’s another measure that supports capital spending growth, from here. Net cash flow at companies is positive, at 105% of nominal GDP.
In the short term, higher U.S. growth sparked by increased capital spending might cause an “overheat panic,” and a nasty correction in stocks and bonds, because of worries about wage and price inflation, and Fed tightening, believes Paulsen. After that, the higher growth would boost investor confidence and bring a “prolonged economic and stock market recovery,” he says.
That would be the next leg up in the bull market for stocks.
Tech stocks might be a good way to play this, since they’ve typically outperformed during capital spending cycles over the past 50 years.
This scenario of possible volatility followed by another leg up for stocks underscores an age old investment maxim espoused by Warren Buffett: Invest for the long term. You should never put money in stocks that you might need over the several years.