This past August, investors got obsessed with the idea of a double dip recession. With that the market pressed down to Dow 10,000 with many experts looking for a lot more losses to come. From that darkest hour we have emerged with an impressive rally lasting over two months.
Now the question on everyone’s mind is: What’s next for the stock market?
I strongly believe the answer is that we are due for more gains. Not just because there is no double dip. More importantly, there are sound fundamental reasons for the market to continue its advance. Here are 4 such reasons:
1) Corporate Earnings
We just came through another strong earnings season. And the simple fact is that the health of corporate earnings has more to do with the movement of stock prices than any other measure. (If this is news to you, then perhaps you forgot that buying stocks is about buying an ownership stake in a company. And owners of companies don’t care about the “chart pattern” of the stock price. They care about the stream of earnings they will receive in the future.)
So how good was Q3 earnings season, you ask?
- 3.87 stocks had a positive surprise for every 1 that was negative
- The average positive surprise showed earnings 5.0% above expectations
- 1.37 positive estimate revisions ratio. Meaning estimates are moving up for the future
- Year over year growth looks like +42%
2) Valuation
Thanks to the strong earnings noted above, the bottoms up estimates for the S&P 500 next year currently stands at $93.21. This means that the S&P is only trading at a PE of 13.1. That is very reasonable by historical standards.
Now consider the earnings yield of stocks, which is dividing the $93.21 in earnings by the current S&P price level. That comes out to 7.64%, which is VERY attractive compared to the meager 2.6% yield on the 10 year Treasury. This last point has been a big driving force behind the rally in stocks that takes us to where we are today. And as you can see, there is plenty of room for it to reach higher valuations without being considered too pricey.
3) End of the Bond Rally
After 30 years of the bond rally, it would appear that we have reached bottom or very close to it. This is especially true since the Fed did embark on QE2. Why’s that? The Fed is concerned about deflation. So they want to spark some inflation by lowering rates on bonds. But bonds are GREATLY influenced by future inflation expectations. So if QE2 helps to spark some inflation, then by definition it will raise Treasury rates and thus end the 30 year bond rally.
When this happens, then more money will flow out of bonds and seek better rates of return. Given what I shared above, investors will be hard pressed to find a better alternative than stocks.
4) Individual Investors Ready to Get Back In
Survey after survey shows that the average individual investor has been scared out of the stock market given the precipitous drop after the Financial Crisis. Then toss in this year’s tremendous volatility and you can understand why they’ve been saying “no thanks” to stocks for a while. But given human nature, they won’t stay away for long.
Now that the market has pushed to new highs, the media is starting to make a big deal about the stock market once again. The more this message gets out there, the more individual investors will feel they are missing out again. As they pile back into stocks it will fuel the next rally higher, which will pull even more investors back into the market.
How high can the market get? Given the valuation scenarios I shared above, we can easily make it to Dow 12,000 without being overstretched. And if the pendulum starts to swing away from fear and back to greed, it could go to 12,500 or even 13,000 easily over the next 12-18 months.
What to Do Next?
On the surface I know it sounds like I am saying to just buy any stock and you will profit from this rally. Certainly the rising tide usually lifts all boats…but some boats do a lot better than others.
I suspect this next leg of the rally will be more focused on quality stocks. Mid to large caps with sound balance sheets and healthy growth prospects. In particular, investors will seek safety in these larger dividend paying stocks as an income alternative to the bonds investments they are fleeing. So I do recommend a healthy diet of these kinds of stocks to make up about 50% of your portfolio.
With the remaining 50% you should feel comfortable grabbing up some small caps with explosive upside potential. Of course, I believe that upward estimate revisions and a Zacks Rank of 1 is a prerequisite for these holdings.
Right now I have a portfolio of 14 positions that mirror my recommendations above. Gladly almost all are well into positive territory with signs of much more to come.
If you’d like to see the 14 positions in the Reitmeister Trading Alert, then you are in luck. The portfolio has been closed to the public for a while and now we are re-opening the doors for a brief time.
So if you are interested to learn more, then be sure to do so now since the service will close again Saturday November 13th at 11:59 PM.
About Reitmeister Trading Alert
Wishing you great financial success,
Steve
Steve Reitmeister has been with Zacks since 1999 and currently serves as the Executive Vice President in charge of Zacks.com and all of its leading products for individual investors. He is also the Editor of the Reitmeister Trading Alert Service.
