Arguments With Bears

5/12/2014


While the Dow Industrials and Dow Transports reached all-time highs in late April, neither average has broken decisively to the upside. Broader stock-market measures also remain stuck in trading ranges, and indexes of small-company stocks are near three-month lows.

Bears argue the stock market has stagnated this year for the same reasons that yields on 10-year Treasury bonds are near six-month lows below 2.6%: The U.S. economy and corporate profits are faltering, and the world is a mess.

It's hard to argue with their assessment of global affairs. If the conflicts in Ukraine or Syria deteriorate into broader regional wars or disrupt energy supply chains, the hit to the global economy could be substantial. But, on present trends, neither conflict seems likely to pose a major threat to U.S. corporate earnings, at least in the short term.

We mostly disagree with the bears regarding the state of the U.S. economy, as recent indicators suggest the U.S. is poised for solid near-term growth. The Dow Transports and Morgan Stanley Cyclical Index, both trading near all-time highs and up nearly 9% over the past six months, seem to support our side of the argument.

The median company in the broad S&P 1500 Index posted 5.3% year-to-year growth in per-share earnings in its most recent quarterly report. The median sales change was 5.1%. While those growth rates are below the respective norms of 9.1% and 6.1% since 1994, most U.S. companies are growing.

Moreover, it's not clear why bond yields have dropped, as there are several plausible explanations beyond a faltering U.S. economy. First, U.S. inflation is low, with the Federal Reserve's preferred measure of inflation up 1.1% for the 12 months ended March — below the Fed's 2.0% target. Second, foreign bond yields are dropping, partly on expectations of further monetary easing in Europe.

Also, the yield spread between corporate bonds and Treasury bonds typically widens when investors are anticipating a weakening economy. That spread is narrowing. The spread between long- and short-term bonds, which typically shrinks in anticipation of a recession, has narrowed somewhat but remains well above long-term norms.

Conclusion

Secondary reactions can occur anytime, even after bull-market confirmations. A typical one-third to two-thirds retracement of the advance since Feb. 3 would put the Industrials at 15,775 to 16,178. For the Transports, the equivalent range is 7,283 to 7,513. We'd view a pullback into these ranges as a correction in an ongoing bull market. Our buy lists have 94% to 96% in stocks.


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