An Epic Bull Market?

If you are in need for some arguments as to why the markets will move higher, take a look at “Get ready for an epic bull market:”

Investors are scared. Workers are worried. And pessimism reigns. Yet in one market, a boom is under way.

I’m referring, of course, to the bond boom: For the year, the iShares Barclays 7-10 Year Treasury Bond Fund (IEF) is up about 14% and the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) up about 12%. Compare that with a measly gain of about 2.4% for the S&P; 500 Index over the same period.

It’s no wonder that investors have yanked $58 billion out of U.S. stock funds this year while pouring $172 billion into bond funds, according to EPFR Global data.

But this very phenomenon suggests we’re on the cusp of a huge bull market for stocks. Here’s why:

This bond bull has been in place for a while: Since August 2000, the S&P; 500 Index is down nearly 17% on a total-return basis, including both dividends and capital gains. Compare this with the total return of 127% on investment-grade corporate bonds over the same period.

The good news is that periods of stocks underperforming bonds are historically very rare and don’t tend to last long. After all, stocks offer something bonds can’t: the opportunity to profit from earnings growth. Plus stock returns offer a measure of inflation protection, which bonds lack.

With investors devouring new credit issues and lowering corporate borrowing costs, companies have lots of free money to spend. And that sets the stage for an epic bull market in stocks — on a scale that hasn’t been seen in generations — as CEOs use cheap credit to enrich themselves and their shareholders.

How epic? Well, a couple of analysts offered realistic numbers this week that would push the S&P; 500 past 2,000, with gains of as much as 85%, based on 2011 earnings. (And then there was the analyst who made headlines this week predicting Dow 38,000, bringing back memories of the famous Dow 36,000 prediction a decade ago. I’ll call this less realistic.)

Over the long term, we can expect big gains. As I wrote in “Why investors shouldn’t be so glum,” we’re at a rare low point for interest rates and near a Depression-era low in the 10-year return of the S&P; 500. Both suggest a multiyear advance lies ahead.

Interest rates are tricky. Fundamentally, they reflect the relationship between the supply and demand for money. But they are also so much more. They reflect inflation expectations. They reflect the level of risk. And they reflect the underlying growth rate of the economy.

So for many, the current bout of ultralow interest rates looks and feels a lot like the situation Japan has faced since the late 1980s (the subject of my column “Is America the next Japan?”). In other words, near-zero interest rates represent a deflationary/low-growth future. In that environment, stock returns should suffer.

But there is plenty of evidence that both the economy and inflation will exceed expectations in the months and years to come — topics I’ve discussed in recent columns (see an index of my columns here). And that means stocks are poised to move higher.

Indeed, a historical analysis by Citigroup strategist Tobias Levkovich shows that cheaper credit does, in fact, boost equity valuations. His data show that the price-to-earnings multiple on the S&P; 500 Index has a strong inverse relationship to the yield on 10-year Treasury notes plus the equity risk premium. The latter reflects how much “extra” return investors demand to hold equities.

Right now, stocks are trading at a P/E of around 13.6 based on consensus 2010 earnings per share estimates. But Levkovich’s model suggests valuations should be closer to 22, given where interest rates and equity premiums are. Based on his 2011 earnings-per-share forecast of $90.25, that would be enough to push the S&P; 500 up near 2,000. Such a rise, if it happened, would be worth a gain of about 74% from current levels.

It gets better: Strategists like Levkovich, who use economic data and historical relationships to make “top-down” estimates, are less optimistic than “bottom-up” stock analysts who examine individual companies. The bottom-up consensus 2011 S&P; 500 earnings per share estimate stands at $96. Putting a 22-times multiple on that estimate would push the S&P; 500 all the way to 2,112, for a gain of 85%.

There you have it; a forecast about as optimistic as only a model can produce. I would not bank on any of these numbers to come true; after all it’s just one man’s prediction. My preference is to stick to reality and let actual market trends tell me where we might be going.

The underlying fundamentals are closer to support the view of potential economic weakness ahead, as the Fed has readied itself to stand by via QE-2 to lend a helping hand should more trouble arise.

That, among many other issues, leads me to believe that we are not (yet) in an environment that easily can set the stage for an epic bull market as the article claims.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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