This Rally Should Have Long Legs
In addition to a rally that could carry this market much higher, we think we are going to have a change in the Sword of Damocles that overhangs this market. At long last, it seems as if a solution for the European Debt Crisis is at hand. It looks as if the spendthrift nations will turn over the control of their budgets in return for the ECB buying their bonds and thus lowering their borrowing costs. Logic doesn't always prevail, but this seems to be a win-win-win deal for Europe, for the spendthrift nations and the stock market.
Clearly European spending/borrowing is on an unsustainable path. When the ten-year Italian bonds hit 7.5% last week, the bond vigilantes were clearly screaming "No Mas." At an interest rate of 7.5%, nothing works. Today, the Journal had front page pictures of the Italian Minister of Labor crying over the possible new cutbacks. Heck, I have plenty of sympathy for people crying as I can shed tears in a Lassie movie. But when a government/people have been borrowing and spending and borrowing and spending well beyond theirincome levels for years and years, I have a very hard time conjuring up any tears. In fact, I have more sympathy for a fellow with a wicked hangover after a long night of over indulging. At least maybe you can pretend that it was a one-time event.
Logic should prevail for both the ECB and the spendthrift nations to reach a satisfactory agreement. We think the Portuguese, Italians, Greeks and Spanish know that there needs to be a major change of course. (The Portuguese have already adopted an austerity budget.) Yes, the austerity budgets will cause pain just like there is pain with a hangover. But no sane person/government believes that over the long-term the spending/redistribution can outpace the growth in productivity. Debt does not produce wealth; productivity produces wealth. Moreover, it may be easier for the national politicians to administer the medicine under the cover that it is not they who are the bad guys but some third party beyond their borders. Even those crying in the streets cannot seriously believe that their economic future will be brighter if the Euro collapses.
The constitution of the Euro Zone was flawed from the beginning because it did not have any power to force the member nations to control their spending. Under the proposed amendment, the central authorities will have this power for non-compliant nations. They also will gladly give back the power once the member nation is in compliance with the spending requirements.
For the European Central Bank, this is the best possible solution for a miserable problem. The ECB would certainly prefer not to be buying these bonds, but this alternative sure beats the break-up of the European Union and all of its possible contagion.
We are thankful for the credit rating function of S&P. By issuing a possible debt downgrade warning today to all 17 European nations, the S&P put even more urgency to this weekend's meeting.
Even the bond vigilantes have testified to the logic of the deal. The yield on the 10-year Italian bonds has dropped from 7.5% to just under 6%. On behalf of the bond market, this implies a major change in expectations.
If the proposed settlement which will be hammered out this weekend is adopted, Europe will not instantly become a healthy and prosperous continent. But it does say that the corrective path has been created and that is all the stock market cares about. The stock market primarily cares about the direction of change or the first derivative, if you will.
For what seems forever, a European break-up and the associated banking contagion has been the Sword of Damocles overhanging this market. If this European Sword of Damocles has been removed, we will show below that this market has considerable room to run. But make no mistake; there will be a new Sword of Damocles over the market. We would guess that it will be our own debt issues. The only time that there is not a Sword of Damocles overhanging the market is the final halcyon, euphoric stages of a bull market -- and we are many, many years from this ending stage.
But not all Swords of Damocles are created equal -- some are smaller and not as sharp. We think the market could have a respite from the current long, sharp overhanging sword. Any sword that contains the word "contagion" is by definition incredibly long and sharp.
The stock market's price is obviously composed of two main factors earnings and the multiple. The beauty of a Bullish forecast today is that the earnings are not in question. The S&P will earn close to $100 this year and likely better than $110 next year. Three quarters of the earnings for this year are already reported and we just finished a quarter where better than two-thirds of the companies beat the expectations. Earnings are on rock solid high ground.
If the current market just carried the average stock market multiple of 16.6, the S&P would be near 1660 which would be an increase of 35% from today's levels. And given the low interest rates, there are many practical/theoretical arguments to support even a higher multiple. There is plenty of room for this market to run without troubling anybody's sense of valuation. And as we all know, investor's valuation parameters move higher as the stock market moves higher.
If our forecast for a year-end rally is correct, it is excellent timing for charities. As it turns out, in deciding the level of our charitable giving, we all place a disproportionate emphasis on the recent results of our portfolios. If you are looking for that extra charity for your year-end Stocking Stuffer, we are always pleased to recommend The Home for Little Wanderers (271 Huntington Avenue, Boston, MA 02115). The Home's mission is to give every temporarily troubled kid his or her best shot at the starting line in life. Your gift will bring lasting cheer to many, many hearts. Happy Holidays!
Peace be with you and your portfolio,
Harry E. Wells, III
WellsAssetManagement.com
December 5, 2011: S&P 1255