Is this rally for real?

January 31, 2013, 4:13 pm Peter Switzer Yahoo7

Confidence should build over the year with stock prices going in the same direction.

It’s one thing to have a nice rally on the stock market, which has run from mid-2012 and has seen the S&P/ASX 200 index go from 3985 to levels around 4835 — that’s a 21% spike. History has shown that a stock market often anticipates what is set to happen in the real world or economy.

That makes me relatively confident that stocks will continue to rise this year, though I expect to see some dramatic moments that will bring doubt over the rally, but I will be using these negative periods as buying opportunities.

Out of bonds, into stocks

As March looms, the US Congress will debate automatic spending cuts due on March 1, and the associated debate in February could unsettle markets.

Then in May, the Congress has to deal with the debt ceiling limit, which could be used as a trigger for traders to “sell in May and go away”, as the old market rule of thumb says.

I think a rotation is on the way where people in the safety of bonds or term deposits are now looking at income-paying stocks simply because there’s a need to get better yields. The safest way to do it with stocks is via great name companies that make good profits, and consistently pay dividends.

CNBC’s Jeff Cox last week pointed out, “Some $600 billion has come out of equity funds since 2006, while $800 billion has gone into the comparative safety of bond funds. That trend has changed recently, with $35 billion back in stock-based funds in the past two weeks, $19 billion of which is in long-only funds.”

Another plus for stocks is the belief of many experts that “stocks are cheap”. Let me simply prove my point. When the S&P 500 index was last at the 1500-level, the market price-earnings ratio (P/E) was 16.5, but it’s now at this level and the P/E is only 13.5.

Good US data

Also the run of economic data in the USA is overwhelmingly positive with the jobless claims level at five-year lows — that’s pre-GFC levels! On top of that, the housing sector is firmly in recovery mode and US companies have $1.8 trillion of cash on their balance sheets! One day this has to be unleashed and put into business investment, which will spark economic growth as well as jobs.

Consistent with an improving economy, US company reports for S&P 500 companies have been better than expected with some 147 companies playing show and tell with 68% beating on expectations of earnings and 65% topping on revenue forecasts. That’s a very good sign.

Meanwhile, China's economy is tipped to grow at 8%-plus in 2013, which will help the global economy and material stocks such as BHP Billiton and Rio Tinto. This will help our stock market.

Europe getting better

We’re even getting good news out of Europe with bond yields staying low, which helps government funding needs, and there’s even talk that Spain won’t need a European Central Bank (ECB) bailout.

In addition, the ECB has a more bullish take on potential economic growth for the Continent and the central bank’s president, Mario Draghi is telling us that he expects a “positive contagion” is developing to replace the one that has dominated since late 2007 and in the GFC.

Even the German Chancellor, Angela Merkel, is making comments showing that she has guarded confidence on the outlook for Europe. Much of this positivity has been reinforced by the recent meeting of top, global business and government leaders at the massive talkfest held in Davos, Switzerland at the end of January.

Confidence building

Locally, there’s bound to be signs of a slowing economy with unemployment set to rise, but I think the RBA will cut interest rates and slowly our economy will pick up, in part helped by the improving stock market.

I think confidence will build over the year and stock prices will go in the same direction. The recent Deloitte survey of chief financial officers supports my view.

“A solid 70% of CFOs expect to see positive revenue growth in the coming year and 63% expect an increase in cash-flow over the same period. These two key indicators have been steadily increasing over the past two quarters,” said Deloitte’s chief operating officer, Keith Skinner.

What could go wrong?

Things will go wrong this year. Political, and even banking, issues in Europe could make negative headlines and then there will be annoying fights in the US Congress followed by ominous warnings from the likes of Moody’s, the International Monetary Fund and other organisations that can be seized upon by media outlets to create short-term concerns.

Bill Clinton once wisely observed that “it’s the economy, stupid” and that is the main game not just for politics but the stock market and our material lives. As an economist, I think the economic story is heading in the right direction for 2013 and so stocks should follow.

DAX points to European comeback

One final point to reinforce my view. Everyone would agree that Europe is the basket case economy to worry about, yet the German DAX, the stock market indicator for Europe’s strongest economy, has gone up 31% since June 4. As a stock market tries to guess where the economy and company profits are going, this is a strong pointer that Europe is on the comeback trail out of recession. It won’t be anything flash, but it will be a whole lot better scenario than what we expected this time last year.

In a nutshell I think a positive contagion will replace the negative contagion we have endured since 2007, and that will make the difference. So, for 2013, this stock market rally is for real.

Peter Switzer is the founder of the Switzer Super Report, a newsletter and website for self-managed super funds.

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