For anyone who owns stocks, the holiday season was pretty grim. But that’s behind us, and now it’s time to deploy the rest of any buying power you may have. Or put on a little margin if that’s the only way to increase exposure to stocks at this point.
The reason: The bottom is in, and 2019 will bring a 15% rally in the S&P 500 (.SPX), — or better.
How do we “know” the bottom is in? Of course, no one can know this for sure. But that’s what the weight of the evidence suggests. Here are five reasons why.
1. We saw capitulation
Once a selloff gets momentum, the key is to wait out capitulation. If you follow just one sentiment measure to gauge when the collective mood of investors hits extremes, make it the Investors Intelligence Bull/Bear ratio.
Whenever this survey of investment professionals falls below 1, it’s a sign negativity has peaked and it is time to buy. Following the market train wreck in late December, this sentiment gauge fell to 0.86. Bingo.
(Conversely, when this gauge rises above 5, it is a time to trim positions and be careful with stocks. It was above 5 last summer, one reason I was telling subscribers of my stock newsletter Brush Up on Stocks to be cautious on stocks.)
Two other measures I track also signaled capitulation. The VIX volatility index (.VIX), recently spiked above 35. And the Cboe Options Exchange 10-day put/call ratio rose above 1. Both suggest that negativity probably peaked.
2. There’s no recession around the corner
While these signs say the selling peaked, you should never arrogantly write off big stock-market selloffs. The stock market represents the collective wisdom of every person who is smarter at economic forecasting than me (and probably you). That’s why economists say the stock market is a good leading economic indicator.
But we also know that investors routinely lose their heads and sell, or buy, to extremes. So the stock market isn’t perfect as an economic forecaster. In fact, since World War II it has been no better than that coin in your pocket. Near-bear markets or worse (declines of 19% or more) have predicted 14 of the last seven recessions since then, according to FactSet.
It’s unlikely we’ll see a recession soon, says James Paulsen, Leuthold Group’s chief investment strategist, because few of the typical signals have popped up. The yield curve hasn’t inverted. Junk bonds haven't sold off enough relative to safer forms of debt. We don’t see the kind of overheating that typically precedes recession. Inflation and interest rates remain subdued. Consumer and business confidence are solid but not at extremes. And there are few signs of excesses in the economy — like massive debt loads or the housing bubble that foreshadowed the financial crisis. Paulsen expects U.S. GDP growth to fall below 2% this year, but not turn negative.
3. Insiders are very bullish
The men and women with the front row seats on the economy — corporate insiders — turned steadily more bullish as the stock market declined late last year. They continue to buy more of their own company stock than they sell. This is rare and very bullish, according to Vickers Stock Research, which tracks insider activity.
4. Stocks look cheap
S&P 500 stocks traded as high as 24 times trailing earnings last year, putting them the top fifth of the valuation range since 1990. Recently, they fell to the bottom fifth of that range, or about 16 times trailing earnings, points out Paulsen.
“The stock market is back to a level which offers some potential upside again,” he says.
This assumes inflation and interest rates stop rising and the economy avoids a recession — his baseline forecast.
5. There will be progress in the war on trade
Back in late November when investors were sinking deeper into despair, I wrote that shocks from two chest paddles would bring their sentiment back to life and revive stocks: Reversal by the Federal reserve of its aggressive 2019 plans to raise interest rates, and progress in the war on trade.
Last week, we got a definitive signal from Fed Chair Jerome Powell that he’s abandoning aggressive 2019 rate hikes for now. This sparked a big rally. Next, we’ll see definitive progress in the U.S.-China trade tensions. The threat of tariffs has distracted many business managers from their regular jobs, because they’ve had to plan supply-chain contingencies if tariffs hinder access to Chinese factories. This hurts the economy.
Indeed, tariff threats have contributed to a significant economic slowdown in China and the U.S. Chinese leaders feel the pressure. So does President Donald Trump. The 2020 presidential election has already begun, and Trump needs a strong economy and stock market to help fight off contenders like Mitt Romney and Elizabeth Warren, who are already sniping at him.
Yes, Congress is now split so Trump has less leeway. But the president has a lot of power in terms of influence and regulatory reform that can bolster growth ahead of a major election. This explains why the third year of the presidential cycle is normally the strongest for stocks, with a median return of 14% since 1900, according to Tobias Levkovich, Citigroup’s chief U.S. equity strategist.
The bottom line
All of this adds up to a 10%-15% rally from here, suggests Paulsen. His logic? The S&P 500 recently traded at a price earnings multiple of about 16. Assuming earnings are flat but optimism returns because inflation and interest-rate pressures ease, it’s not unreasonable to think the market P/E could expand to between 18 and 20. That suggests the S&P 500 could rise to between 2,800 and 3,000.
Citigroup’s Levkovich is on the same page. His panic/euphoria sentiment model recently went into “panic” mode. The average market advance from that point is 18%.
What to buy?
You could simply buy the S&P 500, the Dow Jones Industrial Average (.DJI), or the Nasdaq Composite COMP (.IXIC), but you are better off focusing on the cyclical names, believes Paulsen. This makes sense. They are the ones that got hit the hardest. They tend to rebound the most when investors get more bullish. And corporate insiders definitely agree. I track their activity daily for my stock letter, and they have decidedly favored economically sensitive cyclical stocks in the pullback since early October. Here are the key cyclical areas to favor, according to Paulsen and some of the stocks that insiders currently favor in each group.
• Energy insiders have been big buyers at Matador Resources (MTDR), and Encana (ECA), among many others. Another way to go here is to buy the energy exchange-traded funds. Bear Traps Report author Larry McDonald, who is currently bullish on the energy sector, suggests Energy Select Sector SPDR Fund (XLE), and VanEck Vectors Oil Services (OIH), others to consider: Vanguard Energy Index Fund (VDE), and SPDR S&P Oil & Gas Exploration & Production (XOP).
• Industrials insiders have been big buyers at Air Products & Chemicals (APD), Univar (UNVR), and Eastman Chemical (EMN), for ETFs, consider the Industrial Select Sector SPDR Fund (XLI), Vanguard Industrials Index Fund (VIS), and Fidelity MSCI Industrials Index (FIDU).
• Financials insiders have been very bullish at Century Bancorp (CNBKA), B. Riley Financial (RILY), and Greenhill (GHL), also consider the Financial Select Sector SPDR Fund (XLF), Vanguard Financials ETF (VFH), and SPDR S&P Regional Banking ETF (KRE).
• Technology insiders have been significant buyers at Intel (INTC), Appian (APPN), and SS&C Technologies (SSNC), Here are some ETFs to consider: Technology Select Sector SPDR (XLK), Vanguard Information Technology (VGT), and iShares U.S. Technology (IYW).
What to avoid
Be wary of the FAANGs since many of them have problems that will persist. Regulators are now looking at Facebook (FB), and Google parent Alphabet (GOOG), (GOOGL), which is never a good thing. A slowdown in sales growth at Apple (AAPL), suggests it may be done riding the innovative wave set in place there by the genius of Steve Jobs years ago.
Use rallies to get out of defensive names in sectors like utilities, consumer staples and big pharma, says Paulsen.
Also, avoid thinking of cyclical names as long-term buy-and-hold stocks, says John Normand, head of cross asset fundamental strategy at JPMorgan Chase. Though cyclical stocks will see continued strength from here in 2019, we are in the late stages of this expansion. When economic cycles end, that is invariably bad for cyclical names.
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