Back in December last year I outlined a number of factors that were bullish for US large-cap blue-chip stocks, and said that they would continue to be the primary beneficiary of the Fed’s policy of QE-to-infinity and other favourable macro forces. Back then the Dow was trading at around 16,000, and despite the fact that the index has risen by more than 7% since then, my bullish outlook has not changed. In this article I explore more reasons to be bullish on large-cap US equities.
As the chart below shows, large-cap US stocks are in a powerful uptrend, and despite the fact that the US central bank is in the process of winding down its quantitative easing stimulus programme, there are still plenty of reasons to remain bullish on US equities.
Chart courtesy of stockcharts.com
In March 2009 the US stock market made a generational low which marked the beginning of what I believe will be a major new secular bull market that could well last for another 3 to 5 years, and possibly much longer.
History shows, that since the industrial revolution, every one of these long-term secular up-trends has been driven by the same fundamental factors. These are, demographics, valuations, and the credit cycle, so it’s worth starting by addressing each of these.
There is a strong coloration between favourable demographics and US economic expansion and history shows that the stock market can lead this economic expansion by as much as 5 to 7 years. Perhaps the best example of this was the post–World War II baby boom generation that helped drive the economic expansion and stock market boom that began in the late 1980’s and lasted until around the year 2000. This period of prosperity and rising stock prices coincided with the 76 million or so baby boomers forming households and reaching their peak earnings potential.
The US economy (and others), now looks set to benefit from another demographic windfall in the form of the Millennials who were born between 1982 and the year 2000. The bulk of the 85 to 90 million Millennials are in their mid-twenties and will be heading into the same household formation and peak earnings pattern over the next few years.
At around 20 times earnings US companies, as represented by the S&P 500 are not cheap, but nor are they expensive. While institutional money managers are sensitive to valuations, individual investors typically tend to be less value oriented and tend to enter the bull market in its later stages chasing returns. This is why at the end of a typically bull market cycle, stock valuations tend to reach the high 20s or low 30s.
The credit cycle
The credit cycle is another major driver of economic expansion. In fact, credit is such an important factor that there has never been an economic expansion in the US against the backdrop of a contraction in the credit markets.
It was the expansion of credit that fuelled the expansion that culminated in the global financial crisis of 2008. Since then however, US corporations have been deleveraging. They have also cleaned up their balance sheets, refinanced their debt at lower interest rates, and have becoming leaner and more productive. This has put the US private sector in a strong position and has left it flush with cash.
US consumers have also taken steps to put their finances in order, with outstanding credit-card debt recently falling to the lowest level since 2002.
The ratio of debt to disposable income has also fallen since the crisis, however, neither corporations nor US consumers are keen to go out and spend, and therefore all the money that has been accumulated is simply sitting on the sidelines. Until this changes the disconnect between the performance of the stock market and the performance of the economy is likely to continue.
Other factors driving US equities
In addition to these fundamental drivers, there are several other reasons to be bullish on US equities, including:
- The US is enjoying a manufacturing renaissance with companies such Chrysler, GE, Rolls-Royce, Caterpillar and Siemens all opting to move productive capacity back to the US.
- The US continues to benefit from an energy revolution. Domestic oil production has increased by around 2.4 million barrels a day since 2008, something which has not only reduced the price of energy, but has also reduced the trade deficit in petroleum to its lowest in more than five years.
- US companies are sitting on a record $1.64 trillion in cash. Right now this cash is being used to buy back stock and pay out dividends, both of which are bullish for investors. However, if and when these companies feel that the economy is strong enough, this cash can be invested in new productive capacity and expansion into new markets.
- The public and a good number of professional fund managers are not yet participating in this market. The participation of these groups will likely fuel the final phase of this bull market.
- As interest rates slowly begin to rise money is likely to flow out of the bond market and into large-cap US equities.
- Thanks to falling bond yields, central banks around the world are now putting their $11 trillion in foreign-exchange reserves to work in the stock market. These institutions are buying record amounts of stocks, and are likely to be focusing on more conservative dividend paying stocks.
- It is rarely talked about, but the supply side of the equation has also improved, with the number of US stocks falling quite considerably since the last bull market in the 80’s and 90’s. Thanks to mergers and acquisitions, and companies going private, the number of listed US equities that are available to the average investor has fallen by around 40 to 45% over the past 30 years.
The news for investors isn’t all good. The Federal Reserve is now in the process of ramping down its QE programme and there can be little doubt that this has been a significant driver of the financial markets since the financial crisis erupted. However, all the excess liquidity that has been pumped in to the banking system is not going to go away when QE ends, and the effects of QE will be felt in the stock market (and eventually the economy), long after the Fed has finished tapering.
It’s also worth noting that the Fed (which is the only institution that can actually reduce the amount of money in the system) has no intention of withdrawing any of the liquidity any time soon.
In an ideal world the Fed would like to be able to turn off the flow of stimulus and also raise interest rates. This would give the central bank some ammunition that it could use when the next crisis occurs. However, it is not yet clear whether or not the US economy is capable of growth without massive injections of stimulus, and if the Fed’s action leads to a pronounced economic slowdown, and, or a significant decline in equity markets, the Fed is certain to reverse course.
Delay and pray
Just like other heavily indebted developed nations the US is playing a game of delay and pray. In fact, a recent report from the Trustees of the US Social Security and Medicare trust funds predicts that the Social Security trust fund will be bankrupt by 2033 and will have to pay out 23% less in benefits. They also predicted that the Disability trust fund will be broke by 2017, and noted that the Highway Trust Fund is also nearing insolvency.
Since 2008 US debt has increased by $8 trillion, and by the time President Obama leaves office the US will have around $20 trillion in debt. So the problem of too much debt hasn’t gone away. Sooner a later the sovereign debt crisis will reach US shores. The only question is: How long can the US continue to extend and pretend, and will that buy them enough time to find the political will to make the necessary reforms?