Why the Outlook for U.S. Stocks Could be Much Better Than You Think

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Could the U.S. bull market actually be for real?

That's the question investors have been asking since U.S. stocks essentially bounced off of their March 2009 post-crash lows – only to be launched into one of the strongest rallies in U.S. market history.

More than a year later, U.S. investors still don't know what to believe – or what to expect, says Jon D. Markman, a market commentator and best-selling author who is also a Money Morning contributing writer. The most recent sentiment poll by the American Association of Individual Investors, or AAII, showed that only 41% of investors are bullish. Cash flows at mutual funds that invest in U.S. stocks are telling a similar story, with a $5.1 billion monthly outflow, Markman says the most recent data shows.

"Despite the 6% move for the major U.S. indexes this year, sentiment remains morose and skittish as investors appear willing to listen to any ghost story that comes along,"; Markman says. "Who can blame a person for being anxious, though, right? With high deficits, persistent unemployment, more taxes on the way, and a fortress Europe that's driven by old jealousies and new debts,"; it's no surprise investors are three parts worried and one part cautious.

However, a number of factors bode well for U.S. stock prices going forward. Key among them:

  • This has been a liquidity-driven market: An accommodative U.S. Federal Reserve got the rally off the ground and up into the air – after which the federal bailouts and the Obama administration stimulus provided a healthy enough tailwind to allow the market rally to gain altitude. There's more to come: At last count, only about a third of the Obama administration's $862 billion stimulus package had been spent.
  • Only one other bull market in U.S. history posted a stronger first year. And history shows that strong first-year bulls tend to see robust follow-through.
  • Despite the market's strength, many investors refuse to acknowledge this as a full-fledged bull – the kind of "wall of worry"; that keeps an orderly, conventional bull market from making the leap into a full-fledged speculative frenzy.
  • The Dow Jones Industrial Average closed higher on 18 of the 23 trading days in March, making it the most consistently positive month (78.3%) since April 2007 and ranking it as the 14th most positive month for U.S. stocks in 110 years.
  • Earnings are on the rise and merger-and-acquisition (M&A) activity is accelerating – bullish activities that can help put a floor under stock prices, and perhaps even push them higher.
  • And finally, with bond yields and interest rates on cash so low, many investors will have no choice but to turn to stocks at an increasing rate.

Let's take a look at some of these key factors…

It's All About Liquidity

Back in his days as a top-of-the-lineup table-setter for the Milwaukee Brewers and others, Hall of Famer Paul Molitor was known as "The Ignitor"; for the way his hitting could spark major rallies.
Make no mistake about it: Given the horrid economic backdrop against which this bull market began, liquidity – not optimism – has been the key "ignitor"; of the near-record rally in U.S. stock prices.

And that's not likely to change anytime soon.

The U.S. Federal Reserve continues to hold its benchmark Federal Funds target rate at a historic low near zero. While there's always a chance for a near-term correction after such a rapid run-up in stock prices, the super-accommodative stance by the nation's central bank is likely to keep U.S. stocks on an upward trajectory, says Money Morning Chief Investment Strategist Keith Fitz-Gerald.

"Look, I would not be at all surprised to see a 10% correction here in the near term … after which I think the market will meander higher, absent a change in Fed policy," Fitz-Gerald said. "As long as the Fed continues to decide the bill [for the economic bailout] isn't due, we have no choice but to be long."

And U.S. monetary policy is only half of an equation whose solution seems to point to higher U.S. stock prices – there's also a stimulative fiscal policy still at work here.

Although the Obama administration still uses its original $787 billion estimate when referring to its stimulus package, the nonpartisan Congressional Budget Office (CBO) recently boosted its cost estimate of the stimulus to $862 billion, according to CNN.com.

And there's still plenty of that money to be spent.

In fact, even the bulk of the initial allocation has yet to leave the government's hands. Through the end of January, roughly $334 billion in spending had been approved, although only $179 billion had actually left U.S. government coffers. An additional $119 billion financed tax cuts, CNN reported.

When the Obama "Recovery Act"; stimulus was first announced, the U.S. economy was in a virtual freefall. With such a grim outlook, most of the spending was earmarked for such direct-aid benefits as unemployment payments, as well as for tax relief.

With that plunge now arrested – and some parts of the economy actually showing signs of life – senior Obama administration officials have vowed to shift the spending "mix.";

During the first year of the stimulus program, Recovery Act spending averaged about $27 billion a month. That will jump to $32 billion a month in Year Two, administration officials have said.

As of the end of February, only $31 billion had been spent on projects such as infrastructure, healthcare technology, broadband access, and even high-speed rail. But as recovery spending enters this new phase, the amount of money that's funneled into these initiatives will more than double – reaching $7 billion a month as work accelerates.

The bottom line: The Obama administration intends to disburse 70% of the alloted Recovery Act money – about $551 billion – by Sept. 30, a move top officials claim will set the stage for a lasting economic expansion. As that money rolls through the economy, it will boost incomes for – and spending by – U.S. consumers, will ratchet up business spending, and will eventually work its way into corporate profits.

"Many projects are just now getting under way, and will be creating jobs throughout 2010 and beyond,"; U.S. Vice President Joseph Biden told journalists recently.

The Dow's consistently profitable months

The "Bridesmaid"; Bull Market

U.S. stocks soared nearly 70% in the 12 months that followed their March 9, 2009 post-crash lows, making the first year of this bull market the second-strongest in U.S. history. The only other stronger first year to a bull market was from March 1935 to March 1936, when the Standard & Poor's 500 Index rallied just under 77% in a year, according to the noted market-research firm, Bespoke Investment Group LLC. During that bull market, the S&P 500 went on to gain an additional 31% before its peak.

That's the thing about bull markets: When they start strong, there tends to be follow-through.

And yet, some investors are still refusing to label this as a true bull market.

To answer that challenge, Bespoke researchers also looked at stock market "breadth" to see how strong this rally really has been. Breadth is a technical-analysis tool forecasters use to gauge a rally's sustainability. They look at how many stocks are advancing versus how many are declining, reasoning that a broad-based advance signals a healthy market.

After adjusting for the explosive growth in the number of issues we've seen through the years, Bespoke found that the only other first year of a bull market with stronger breadth was a 12-month stretch from 1942-1943.

In fact, not only was the March 9, 2009 to March 9, 2010 stretch the second-strongest-showing for market breadth in a first-year bull market, Bespoke says the breadth readings for the past 12 months "are among the strongest … we have ever seen for any one-year period."

Since 1928, there have only been three other periods like the present where the average daily breadth reading over a one-year period exceeded 7.5% of all New York Stock Exchange-listed stocks, Bespoke said. Those one-year periods began in February 1943, February 1945 and January 2004.

"In spite of the fact that by multiple measures this bull market has been among [the strongest] – but not quite the strongest – ever, it just never seems to get the recognition it deserves," Bespoke wrote in a recent research note. "As the old saying goes: 'Always a bridesmaid, never a bride'."

Sunny April

Investors could be excused if they didn't want to see the 2010 first quarter come to an end. After all, U.S. stocks enjoyed a strong first quarter, capped off by a very strong month of March – partly because of earnings that easily eclipsed expectations.

The S&P 500 rose 5% for the year's first three months, topped off by a 5.9% gain in March, its best first quarter in a dozen years. The last time it was stronger was in the first three months of 1998, when the S&P rose 13.5%, Howard Silverblatt, an analyst at Standard & Poor's, told MarketWatch.com.

The Dow Jones Industrial Average rose 5.1% in March and 4.1% for the quarter. The Nasdaq Composite rose 5.7% for the quarter, thanks to a 7.1% jump in March, according to MarketWatch.

"Chief among bullish drivers has been a strong fourth-quarter earnings season fueled not only by cost-cutting, but also by top line growth," Alec Young, equity strategist at S&P Equity Research Services, wrote in a research note.
It's understandable if investors are left feeling wistful about March. But here's a key point to consider.

April could be even better.

Historically, April has been one of the best months of the year for U.S. stocks. During the last 100 years, the Dow has posted an average monthly gain of 1.32% in April, which ties it with December as the most positive month for the index.

Over the last 50 years, however, April has actually been the best-performing month for U.S. stocks, Bespoke researchers found.

Over the last 50 years, the average monthly gain for the S&P 500 has been 0.60%. When the index was up more than 5% in the previous month – as it was in March – the index averaged a gain of 1.12%.

Since April 2003, the S&P has gained more than 5% in a month nine times. The S&P posted a positive return the following month all nine times.

It's All About Earnings

Earnings expectations typically drive markets. Or at least that's the theory.

As Money Morning's Markman points out, market bulls have been expecting a profit recovery for much of the past year. That recovery has arrived – and it is even a bit better than the bulls had hoped. That could bode well for stock prices going forward.

ISI Group Inc. now estimates that corporate profits will increase 38.8% for the first quarter on a year-over-year basis. Profits will then zoom 42.4% in the second quarter, 36.8% in the third quarter and then 30% in the fourth quarter – against admittedly tougher comparisons. That would mean that corporate profits rose a record 36.1% for all of 2010.

If profits increase by that much in 2010, ISI analysts forecast they will hit $1.86 trillion by the third quarter of this year, which would be a record by a wide margin, as you can see in their chart, above.

Why is this relevant? In the 1930s it took U.S. profits 12 years to hit a new high after crashing in the early part of the decade, ISI reported. In Japan's "Lost Decade(s),"; it took 16 years.

Here in the U.S. market, profits are now projected to hit a new high this year – just four years after their prior peak.

"This information helps us understand that the current rebound is unique in its robustness relative to prior recoveries in the past century, most likely because of the united front put forward by governments and central banks to stimulate on a vast scale,"; Markman says.

March Merger Madness

When the Dow hit its all-time high north of 14,000 back in October 2007, it was aided by a dealmaking tailwind – a raucous mergers-and-acquisition market that helped push stock prices to those record levels.

Today, just a bit more than a year since the U.S. economy hit bottom during what some pundits have labeled as the "Great Recession,"; U.S. firms are sitting on an aggregate $1 trillion in cash. That cache of cash could serve as the kind of capital wave that ignites the long-moribund U.S. M&A market and ignites the next leg of the U.S. bull market.

In Year Two of this rally, a frenetic dealmaking market could be enough to push stock prices to new highs.

As a rule, an increase in M&A activity is a bullish sign for both the economy and the stock market, says Money Morning Contributing Editor Shah Gilani, who tracks deals for his own advisory service, The Capital Wave Forecast. As far as capital waves go, this surge in cash-driven deals is potentially one of the most powerful catalysts in the market right now.

"Deals getting done is indicative of a positive outlook for the economy in that acquiring companies are looking to expand their businesses," Gilani explained. "In the current environment, most dealmaking is centered on extending the acquirer's market share and reach with regard to existing business lines – and that's healthy."

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About the Author

Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning. With his latest project, Private Briefing, Bill takes you "behind the scenes" of his established investment news website for a closer look at the action. Members get all the expert analysis and exclusive scoops he can't publish... and some of the most valuable picks that turn up in Bill's closed-door sessions with editors and experts.

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