Why Stocks Will Be Up 20 Percent by June

As the month of March rolled around many money managers, including myself, started to turn bearish or neutral on stocks based on that 1) we have been going up too much too fast (the S&P 500 index was up 9% as of the end of February), 2) we have exhausted all catalysts as all good news was priced in, and 3) European debt crisis has not been resolved yet and was likely to get worse. Since then, the S&P 500 is up another 2.4% to bring total returns for the year, as of March 15, to 11.4% and the banking sector was given an overwhelmingly clean bill of health via the latest stress test results.

Notice that none of the 3 reasons I cited above for a pullback have to do with something negative per se with US stocks but rather they are reasons that either have to do with Europe or with the speed and level of the advance we have seen in stocks so far. Today, headlines of the European debt crisis are hardly to be found in the financial media after a Greek debt deal was reached earlier this month. Economic headlines have continued to show that the economy is enjoying material growth – particularly in jobs creation. The mean reversion in stocks that everybody was expecting is not likely to happen in the near future because of the following 4 reasons that I think will push stocks higher by another 10% by June.

- Bernanke’s Virtual QE3: I have argued in the past that the FED’s new level of transparency in explicitly stating in its January FOMC statement that economic conditions warrant exceptionally low levels of interest rates through 2014 was a strategy of buying time and extending “Virtual QE3” without actually executing a program of easing. The fact that this language stayed in the FED’s latest FOMC statement on March 13 adds credibility to the idea that if the economy deteriorates then the FED will be there to boost asset prices with more QE and if the economy continues to improve then stocks will go up on their own on the strength of corporate earnings. So far we have seen evidence of the latter but the former remains as a safety net.

- Performance chasing: As I mentioned above, the S&P 500 was up 9% as of the end of February. Hedge Funds however were up only 3.98% on average during the same period according to The Dow Jones Credit Suisse Hedge Fund Index. The best performing domestic strategy was long/short equity with a 6.65% return. Given that many managers were expecting a pullback in stocks and given that stocks actually advanced so far in March one has to think that many long/short managers did not fare well so far in March. So the 5% difference between the performance of the S&P 500 and the DJCS Hedge Fund Index at the end of February has probably increased so far in March adding more pressure on money managers to chase returns and invest aggressively in equities over the next few months in my opinion.

- Fund Flows and relative performance: While the Investment Company Institute has been reporting that mutual fund inflows over the last 14 months have been going mostly to fixed income mutual funds – supported at least in part by outflows from stock funds – new research emerged that investors have been steadily adding to stock funds over each of the first 2 months of this year for net inflows of $5 billion. While modest, this signifies a beginning of a trend in my opinion. Couple that with the dismal performance of Treasury bond fixed income indexes so far in March and I think a lot more funds will be switching to equities soon. To get a better appreciation of the big declines in Treasuries, observe the table below from Standard and Poor’s fixed income indexes and notice how the first two weeks of March have been responsible for most if not all the declines for the year. This is an important table and we will see its ramifications on where money flows in April and how it’s allocated.

Source: Standard & Poor’s

- Technical breakout: As a fundamental value investor I am usually loathe citing technical analysis as a reason to make a buy decision. However, looking at the S&P 500 and Dow Jones Industrials charts you can see a forceful breakout from relatively strong 1370 resistance levels on the S&P and 12,900 on the Dow. When combined with the 3 reason above I believe this upward swing will continue for quite some time and well into the first quarter earnings reporting season in May and June of this year. Levels we are likely to test by then are probably 1550 on the S&P (up 25% for the year) and 14,000 for the Dow. This will not be a straight up move but I do expect markets to make solid gains during the second quarter.

To summarize, this market is going higher on the strengths of the combination of 1) fundamental reasons – good economic reports and a Fed policy supportive of asset prices if those reports disappoint, 2) Mechanical reasons – performance chasing and expected fund flows into equities rather than bonds, and 3) Technical reasons that favor price momentum upwards.

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Tagged NYSE:SPY, NYSE:TNX