Three Reasons to Be (At Least a Little) Bullish

Updated Friday, August 6, 2010

After a very gloomy stretch, things are looking up again for the stock market. Can it last?

Who knows? I’m skeptical, mainly because of the weak volume we’ve seen on the current rally.

But looking beyond the next few weeks and into 2011, there are actually some reasons to be optimistic.

First of all, earnings reports from big US companies have been spectacular—and it’s not just because of job cuts, inventory liquidations, and easy comparisons with last year’s lousy second quarter.

It’s because the economy is a lot better than it was a year and a half ago. And besides employment, which is in terrible shape, there are clear signs of improvement in other areas that matter.
 
Finally, there’s the calendar. As we look past the seasonally weak period going into the fall and, especially, the upcoming midterm elections, we actually enter the sweet spot of the market’s cycle. On average, that means very strong gains, although, of course, there are no guarantees.

Let’s start off with earnings, which have been a real bright spot. According to Bloomberg, as earnings season winds up, an impressive 77% of Standard & Poor’s 500 index companies that have reported have beaten analysts’ estimates. And their guidance to analysts about future earnings has by and large been very good, too.

Even more impressive is the 54% growth in profits and, most of all, the 11% increase in sales these companies have posted. You can play around with earnings, but sales are what they are. So, a double-digit percentage increase in revenues shows something is happening. 

But where? Many of the S&P companies are big multinationals that get nearly half their revenues from overseas. And the earnings reports show emerging markets are on fire.

Sales in emerging markets, for instance, powered a 43% jump in profits for 3M (NYSE: MMM) and other companies such as Caterpillar (NYSE: CAT).

Caterpillar, in fact, reported gains across the board, even in the US, as did Intel (Nasdaq: INTC), which had what chief executive officer Paul Otellini called “the best quarter in the company’s 42-year history.” Business purchases of servers and a 20% growth in personal computer sales last quarter fueled Intel’s 34% revenue gain.

Meanwhile, FedEx (NYSE: FDX) and UPS (NYSE: UPS) both boosted their earnings forecasts and said business in Asia was outstanding. But both also noted strength in the US. “FedEx cited better-than-expected volume in its domestic ground business, which...suggests that Internet shopping by US consumers has held up,” The Wall Street Journal reported.

UPS said revenue from domestic shipping rose 7.1% over the same quarter in 2009, while volumes were up 1.2%. Caterpillar reported a 43% surge of machinery sales in North America from the second quarter of 2009—well below sales growth of 62% in Asia and 119% in Latin America, but not too shabby, either.

And in a recent appearance on CNBC, Michael Jackson, chief executive officer of AutoNation (NYSE: AN), the US’s largest auto retailer, disclosed that revenue and retail unit sales jumped 20% over the same quarter a year ago and said business was “booming.” “It all points to a genuine recovery that’s going to be sustainable,” he said.

These early signs of recovery ultimately translate into employment growth—although how much is a big question. Ford Motor (NYSE: F) is hiring again, and Amazon.com (Nasdaq: AMZN), a huge beneficiary of the strength in online sales, has already added 2,200 new workers.

Still, on Thursday, the US Department of Labor reported a disappointing 479,000 workers applied for unemployment benefits for the first time, above the previous week’s 460,000. And while unemployment in July remained steady at 9.5%, the decline in non-farm payrolls of 131,000 was much worse than economists had expected.

Next: Not Expecting the Worst

Nonetheless, even companies that have had mixed results in the US don’t expect the worst. “I think the economic recovery in the US will be uneven,” Bob McDonald, chief executive officer of Procter & Gamble (NYSE:PG) said recently.

P&G’s strategy is to sell premium brands to the employed, while “consumers without jobs..trade down” to more generic products.

Still, he said, “we don’t expect a double-dip recession.” Neither does Standard & Poor’s, which recently reduced the odds of that occurring to 20%, from 25% previously.

So, you have a good recipe for higher US stock prices: continued strong corporate earnings based on phenomenal growth in emerging markets, stabilization in Europe (whose markets have been on a tear), and decent growth but no double-dip recession here.

And although the market isn’t dirt cheap (at anywhere form 12x to 13.5x  projected 2010 earnings for the S&P 500), it’s not historically expensive, either. Call it fairly valued, if you’d like.

Which brings us to the calendar.

We all know the six months from May through October are on average the worst period for stock performance. Hence, the hoary phrase, “sell in May and go away.”

But this year, we also have a midterm election coming up, where a president with weak poll ratings and a poor economy is trying to keep a Democratic majority in both houses of Congress in the face of a very energized opposition.

Sam Stovall, chief investment strategist for S&P, and the author of The Seven Rules of Wall Street, tracks the historical data, and he says the pattern is clear. “In almost all observations, the market declined going in to the midterm elections, then advanced sharply after the midterm election,” he told me.

In the 11 midterm elections featuring first-term presidents since 1930, the market declined eight times before, but rallied ten out of 11 times afterwards.

“The one thing that did jump out at me was the strength of the subsequent year,” he said.

Under Republican first-term presidents, the S&P 500 fell 1.6% from August to October before a midterm, but gained an average of 10% in the following calendar year. Under Democratic first-termers, it declined by 5.9% in the previous months, but surged an average 21.3% the next year. That overall pattern prevailed in five out of five cases where first-term Democrats inhabited the Oval Office.

In fact, Stovall observes, the second and third quarters of the second year of presidents’ terms—which we’re in right now—are usually the two worst quarters of the four-year presidential cycle he tracks.

“But the three strongest quarters are the ones immediately after,” he says.

Sure, this time may be different. The staggering budget deficit, aftermath of the financial crisis, persistently high unemployment rate, and prospects of higher taxes and greater regulation may put the kibosh on the whole thing.

But for me, the real economic improvement I see, the terrific corporate earnings that ultimately drive stock prices, and the weight of market history tilt the balance to a cautious optimism.

So, I’ve started nibbling a bit and will put a little more money into US and emerging market ETFs on any pullbacks.

I won’t go overboard, but I think it’s worth taking at least a calculated risk.