So here we sit, and despite the now nearly five month rally, the market is back to where it was nearly two years ago at around 1350. Europe remains unsolved, growth expectations are still muted, and the future is far from certain. Still, given the market's recent move, most in the investment and trading community are asking if the S&P 500 (SPY) and other broader indexes have another leg up in them.
Given that this is now the third time in two years that the market has risen over 1350, it is worth asking what if anything is different this time? I think the answer, well far from a certainty, is that the economies here and around the world are growing without excessive stimulus from central bank and governments. The current growth trajectory of most of the world's economies is still viewed by many in the trading and investing community as fairly unspectacular.
In this kind of stable but still moderate to low growth environment, it is worth asking what the next catalyst will be to drive the market higher. I think that catalyst will be a move out of fixed income and consumer staple stocks into cyclicals with pricing power that offer more protection and upside if inflation expectations increase. The Fed has had a mixed record on predicting and trying to hedge inflation risks over the last couple decades, and to think that our or any other central bank will time their monetary policy perfectly is expect the unexpected.
While growth in China, Europe, and other parts of the world remains muted, U.S. growth expectations remain steady at 2.5-3%. With the U.S. economy having stabilized and continuing to grow, it is likely that progress on fiscal issues in Europe could lead to at least moderately heightened growth expectations in the eurozone and Asia. While little progress in Europe has on the PIIGS various debt issues has been made to date, it is unlikely the economic picture in Europe will get much worse.
Similarly, in China, which is the most heavily levered economy to Europe worldwide, growth expectations are very low. What is interesting to me, even in this environment, is that inflationary indicators are already nearing warning levels.
While commodities like oil and copper are obviously suspect to a number of factors unrelated to growth expectations; oil is now at nearly 110 dollars a barrel and copper prices are nearing 4 dollars a pound. If these commodities are at fairly high levels with growth expectations low and the dollar still fairly strong, where will these economically sensitive assets be once global growth picks up?
Here the risk lies with fixed income and dividend investors, more than those who are weighted more to the cyclicals. Most dividend and consumer staple stocks are up significantly over the last several years, and stocks like Wal-Mart (WMT) and Altria (MO) trade at around 12-13x next years average earnings estimates. As we can see, dividend stocks have already seen recovered to pre-recession levels.
Also, the bond market, while obviously manipulated by fed actions, is still pricing in muted inflation expectations.
Finally, cyclical and industrial stock remain fairly well below where their stock prices peaked at over the last decade. Also, many of these stocks are trading at multiples of around 10-11x next years average earnings estimates that may very well go up as growth prospects improve throughout the year.
If we look at these charts together they suggest that dividend stocks and bonds are at their 5 year highs, while cyclical stocks still have about 7-8% more upside to reach their 5 year highs.
Now,obviously looking at the market just by looking at these charts is imperfect, but still, the cyclical sector is likely to see the highest revisions upwards in earning estimates if the economy continues to improves, and these companies generally have the best pricing power to pass on inflationary costs as well. Multiple expansion in this sector is likely if growth or inflation prospects even moderately increase because of greater growth expectations coming out of the Euro-Zone and Asia.
To conclude, while dividend stocks and fixed income investments are very different in a number of ways, it is reasonable to think that each sector and asset class will underperform the cyclicals as inflationary and growth expectations begin to rise. With many institutions and individuals likely moderate to significantly overinvested in fixed income and safe dividend paying stocks, the shift in inflationary expectations could cause a rapid reallocation to equities. If this occurs, equities could rise significantly in a short period of time even if growth expectations remain fairly muted.
Also, while momentum names like Apple (AAPL), Priceline (PCLN), and Chipotle (CMG), have had huge moves so far, I think a shift in inflation and growth expectations could lead to industrial and energy stocks providing the new leadership for the next move higher. The market has had a huge move up so far, the hardest trade or investment in this market is still to stay long.
If inflation and growth expectations rise even moderately as the year progresses, it could also be the most profitable one. A quick reallocation from bonds and consumer staple stocks to industrial and other cyclical stocks could also cause a chase for performance amongst many wealth managers whose performance is measure against the major benchmarks like the S&P 500.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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