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Why I'm Sticking By Dow 55,000 - views
BALTIMORE (Stockpickr) -- Let's face it: There are a lot of reasons to hate stocks right now, what with the uncertainty with the Fed, economic jitters in Europe and emerging markets and now the ongoing battle within Congress over funding the government.
But all of that market uncertainty could help to fuel a rally to 55,000 in the Dow.
Yes, I realize that sounds crazy. But just bear with me for a minute, and I'll show you how the big index will get there.
A year ago, I made a prediction that stocks were due for significant upside. Twelve months and nearly 20% later for stocks, few of those key factors have actually changed. From a sentiment standpoint, investors still hate stocks -- and by and large, retail investors don't own them in meaningful numbers.
A perfect example of that comes from Fidelity. The fund management powerhouse is a great proxy for what the retail investor is doing with his money. Years ago, the biggest fund at Fidelity was the Magellan Fund, a stock fund. In today's post-2008 world, it's a $120 billion cash reserves fund.
To quote Wellington Management's Frank Teixeira: "People are protecting their investments from an event that's already happened."
Yes, we've had a historic rally in the years since the market bottomed in March 2009, but that rally hasn't been supported by buying pressure from Joe Public. Instead, it's been propped up by a combination of structural factors and institutional necessity. But as the data from Fidelity show, there's still a lot of money sitting on the sidelines in retail investors' accounts ready to move into stocks when stocks come back into favor.
A New Cycle Begins
None of this is new -- we've seen it before. There are some striking similarities between the period we're in right now and the market conditions of the late 1940s and the early 1980s. History may not repeat, but it certainly rhymes.
After the Great Depression, stocks fell out of favor for retail investors for a full decade as people protected themselves from a crash that had already taken place. The discount rate dropped to near where it is now in the years that followed, and stocks quadrupled in the decade after that. In the late 1970s, stocks fell out of favor again at the heels of the Oil Crisis, prompting BusinessWeek's infamous "Death of Equities" cover in 1979. Stocks more than doubled by the decade after that, and more than tripled by the mid-1990s.
So no, Dow 55,000 isn't a target that we'll see get taken out in 2014, but from a long-term view, the 55,000 level on the Dow isn't unrealistic even if it feels unattainable right now. We've hit similar market growth in both of the similar periods in years past.
From a technical standpoint, the broad market is breaking out of a long-term base that couldn't be much clearer. A year ago, when I first put that sky-high target on stock prices, we weren't at new highs yet. Now that indices have hit a new high water mark in 2013, we've got far more confirmation that we're coming up on another rally leg.
The extremely long-term chart of the Dow Jones Industrial Average below does a good job of showing off the similarities between the rallies that started in the 1940s, the 1980s, and today:
Each of the previous multi-decade consolidations in the Dow has taken on a very similar structure. And after breaking out through resistance, stock prices never looked back.
The Fundamental Factors
From a fundamental standpoint, a prolonged rally in stocks doesn't really make sense. After all, stocks have moved too far too fast from the 2009 bottom, right? Now they're looking expensive again.
But that's not exactly accurate.
As I write, the Dow sports a price-to-earnings ratio of 16.8. It was 16.2 in the last five years of the 1930s and just over 10 in the last five years of the 1970s. (For comparison, the high inflation of the 1970s warrants that P/E discount versus the 1930s and now.) The point is that transformational earnings growth isn't something that's visible at this stage in the cycle yet.
There is a big difference today, however. In 2013, corporate profitability and cash holdings have hit all-time highs, which means that around 25% of major stock index value actually comes from cold hard cash.
We've never seen liquid assets make up so much of stocks' assets before -- and that means that P/E ratios are very much overstated. Stocks are actually much cheaper than they appear.
It's also important to consider what cheap really means for stocks. For value-driven investors who use the last five years as a look-back period, of course stocks look expensive today. Over that time period, stocks were bouncing back from absurd bear-market valuations.
When you're used to driving at 5 miles per hour, accelerating to 30 miles per hour seems pretty fast. But that doesn't mean that it's as fast as the car can go.
A Structural Rally
I mentioned earlier than so far we've largely been in a structural rally. So what does that mean exactly?
Since late 2008, the Federal Reserve has undertaken a policy of quantitative easing that's poured money into the markets by the dump truck full. With Janet Yellen stepping up as the presumptive replacement for Ben Bernanke, that faucet of free money isn't likely to get shut off anytime soon. But then again, it wasn't really going to be shut off anyway.
One result of "QEx" has been an everything rally. In short, stocks aren't the only asset class that's seen prices appreciate at a breakneck pace, it's just the only one that investors don't believe in right now.
Since the market crash, fixed income and commodities have both rallied hard too. When everything's going up, it means one thing: the monetary base is expanding very quickly. Luckily for U.S. investors, everyone else has been printing money too. That, and the safe-haven designation of the U.S. markets, has saved the dollar from getting shellacked.
But in this environment, stocks are the clear outperformer.
Right now, investors are still overweight flight to quality investments like treasuries. But those investments are atrophying away under the low-rate, comparatively higher interest rate environment that we're currently knee-deep in. It doesn't take hyperinflation to create a toxic environment for low-risk assets, just negative real interest rates.
Stocks may not be perfect, but when treasury investors can't take the pain anymore, they're going to have to turn to stocks again. When that happens, the flow of funds will send the stock rally moving in earnest.
Looking back historically, the "Great Rotation" from safety investments to stocks has come between five and seven years after major market bottoms. That should make the next couple of years pretty interesting.
Profit from Dow 55,000
As I mentioned before, Dow 55,000 isn't a price target for next year or the year after. It's a very long-term target that's based on the runs stocks have made in the last two similar periods to today. But now is absolutely the time to get your portfolio positioned for the upside.
The simplest way to profit from Dow 55,000 is to buy stocks as a group. Major index exchange-traded funds such as the SPDR S&P 500 ETF (SPY) or the PowerShares QQQ Trust (QQQ) may not be very sexy, but they give you instant exposure to a diversified equity portfolio with very low fees.
That said, this is very much a stock picker's market. Aside from general stock buying, one of the best ways to play this trend is by honing in on fundamentally solid names that everyone else hates. Heavily shorted stocks have the potential for a short squeeze as sentiment turns, and that's more than just an old wives' tale; my research shows that buying heavily shorted large and mid-cap stocks (the top two quartiles of all shortable stocks by market capitalization) and rebalancing monthly over the last decade would have beaten the S&P 500 by 9.28% each and every year.
That's some material outperformance during a decade when decent returns were very hard to come by.
I'm the first to admit that Dow 55,000 sounds like a crazy price target for stocks right now. But with so many factors lining up to suggest another generational buying opportunity for stocks right now, it'd be just as crazy not to position your portfolio for it in 2013.
-- Written by Jonas Elmerraji in Baltimore.
At the time of publication, author had no positions in stocks mentioned.
Jonas Elmerraji, CMT, is a senior market analyst at Agora Financial in Baltimore and a contributor to TheStreet. Before that, he managed a portfolio of stocks for an investment advisory returned 15% in 2008. He has been featured in Forbes , Investor's Business Daily, and on CNBC.com. Jonas holds a degree in financial economics from UMBC and the Chartered Market Technician designation.
Follow Jonas on Twitter @JonasElmerraji