The Smart Way to Be a Cautious Bull

As a long-term investor, I'm a raging bull. I expect the markets to double in the next five years.

However, as a trader, I'm cautious up here and I'm skeptical of the new record highs stocks just made.

There are a dozen reasons that point to markets continuing to climb for several more years. But markets don't go up in a straight line, though they can have long upswings lasting years.

We just made new all-time highs again in this post-Irma "relief rally," so it's the perfect time to check to see whether there are any serious impediments to going a lot higher in the short haul.

Here's the base case for stocks doubling in the long term and how to survive the short-term pitfalls in front of us...

The Big Dow Double Down

The bull market case isn't just academic, it's positively fundamental.

Since 1998, the number of listed companies on U.S. exchanges has been cut in half. Since just 2007, the surviving listed companies have bought back more than 7 trillion dollars' worth of their own shares, further reducing total shares outstanding.

Because of share buybacks, mergers, acquisitions, leveraged buyouts, industry consolidation, ever larger economies of scale, companies not splitting their shares, the passive investing trend where stocks aren't traded but warehoused, and the complete dearth of IPOs, there will be fewer and fewer shares in the open market for investors to buy.

At the same time, there's more and more capital being created every day.

Besides the tens of trillions of dollars printed globally by central banks over the past 10 years, the market being up more than 260% since 2009 is a source of reinvestment capital scooping up more shares. New money in the form of net profits, globally, is being parked in stocks.

More capital chasing fewer shares is an easy equation to understand. Being bullish is a no-brainer.

Unfortunately, it's not that simple.

I'm a cautious bull up here. There are a few potential pitfalls we need to leapfrog, and we need to know how.

How to Handle the Hurdles

If we can't swerve past these roadblocks, I want to have stops down on all my positions and step aside if any significant profit taking turns into a more serious rout.

Stocks are expensive by almost every historical measure analysts look at. Valuation alone isn't what moves stocks, but it is important when the crowd is nervous about "overvalued" stocks.

Earnings have been positive over the past few quarters, with the second quarter seeing more than 10% growth in earnings for the S&P 500. But a lot of that robust earnings growth in the first and second quarters of this year was enhanced by a 10% drop in the U.S. dollar. If the dollar firms up, that earnings helping hand will flatline.

If interest rates tick up, the dollar will firm, and that might end the earnings run.

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While it's unlikely that interest rates will be driven a lot higher by the Federal Reserve, any uptick in rates could impact earnings. Based on fed funds futures, the Federal Reserve isn't likely to stick to its pronouncements about raising rates a few times this year. But it's still jawboning its intention to start unwinding its balance sheet, which holds more than $4 trillion of Treasuries and other securities.

Not replacing balance sheet holdings that mature and "run off" means the Fed won't be an active buyer in the open market, which could cause rates to tick up as other buyers demand more interest to lend money to the government.

The reason the Fed's unlikely to raise rates in December is that no one knows yet what the cost will be to clean up after Harvey and Irma. And the last thing the Fed wants to do is put upward pressure on rates at the same time funds will desperately be needed for rebuilding.

Still, with the economy showing signs of growth, if there's money available for clean-up and rebuilding in Texas and Florida, then interest rates could start ticking up as demand for money spreads across the economy.

Markets are nervous about the impact of Fed rate hike policies and the great balance sheet unwind, and they're nervous about long-term impacts on economic growth from the costs associated with Harvey and Irma.

If the relief rally that markets have enjoyed can't be sustained, meaning there's no consolidation up at new highs and no new buying, stocks will be prone to slipping backwards.

21,500 is an extremely important support level for the Dow. If the DJIA can stay away from that lower level, there's a good chance we might have another solid leg up.

However, if stocks slip on the heels of the latest push up, everyone will be focused on Harvey and Irma's impacts, on interest rates, on the dollar, and on earnings. And if these pitfalls look like they're weakening the ground the market's climbed up lately, there's going to be another kind of storm.

Be careful out there.

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The post The Smart Way to Be a Cautious Bull appeared first on Wall Street Insights & Indictments.

About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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