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  Pessimists Can’t Keep a Good Market Down
Posted Under: Bullish • Europe • Markets • Stocks

It didn't take long for markets to shrug off a weak May jobs report and media fueled fears of Brexit aftereffects. After dipping below 2,000 in the days following the UK referendum, fears faded, economic data showed a continued strengthening of the US economy, and the markets fully recovered...and then some. This morning, the S&P 500 opened above its prior record closing high of 2130.82, a high that has stood for 13 months.  The pouting pundits of pessimism were wrong again, though we can't say we're surprised. Since 2008, it seems the whole world has hypochondria, seeing recessions around every corner. However, a focus on the numbers rather than the rhetoric shows more strength on the horizon.

At the end of last year we forecast the S&P 500 would close 2016 at 2,375. And following the events in late June we got plenty of questions about lowering our forecasts. We stayed the course. The market remains undervalued and fear mongering doesn't change that one iota. Our valuation is based on our Capitalized Profits Model, which discounts corporate profits by the 10-year Treasury yield.  Given a 10-year Treasury yield that currently stands at 1.43%, the "raw" version of the model says the S&P 500 is "worth" 6,256. Yes, we realize that sounds insanely high. But this number is artificially high because current Fed policy is holding the yield curve "artificially low." Using a more reasonable 10-year discount rate of between 3-4%, instead, gives us a "fair value" calculation. Using this measure, rates would have to rise above 3.75% to take our forecast of 2,375 off the table.

So, what has been holding back the markets? After all the S&P 500 has been flat since May 2015. Constant scare stories by the media combined with the memories of 2008 aren't helping, but as we have said in the past, investors are much better served by focusing on earnings, not fearful forecasts. Yes, earnings were down 6.7% in Q1 versus a year ago, but this was primarily due to the battered energy sector. Looking at the same numbers with energy removed shows a different picture, with earnings down only 1.2%. On top of this, it looks like oil has begun to stabilize, which means energy earnings should begin to move higher in the months ahead. Even with stagnant profits in recent quarters, our models continue to show undervalued markets. As profits rise in the quarters ahead, that will push the markets "fair value" higher.
 
The bottom line is that the economy keeps growing and businesses continue to innovate. The slow growth of the first quarter is well in the rearview mirror, and the economy has been showing faster growth since. In the end, math wins. The markets have erased two 10+% corrections in ten months, and there is still no recession in sight.  The plow horse hit some clay, nothing more. Expect a pickup in momentum moving forward.  

Brian S. Wesbury - Chief Economist
Robert Stein, CFA – Deputy Chief Economist
    

   

Posted on Monday, July 11, 2016 @ 2:08 PM • Post Link Share: 
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These posts were prepared by First Trust Advisors L. P., and reflect the current opinion of the authors. They are based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
 
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