Tanks, Election Can’t Rattle the Bulls

For a week that featured a number of unsociable big events, stocks behaved like they just couldn’t be bothered to stray from their sharp advance out of the Oct. 15 low. Not even reports Friday of Russian tanks rolling into Ukraine could rattle nerves.

The Dow gained 1.1 percent for the week despite the GOP coup in the Senate that may end up disrupting the gains made in health-care stocks in the wake of Obamacare; a lack of new action by the European Central Bank amid chatter of palace intrigue within its Frankfurt headquarters; and the October jobs report that was not nearly as positive as its headline numbers led the media to believe.

Not even reports of Russian tanks rolling into Ukraine could rattle stocks.

The tailwinds — mainly a massive surge in the yen carry trade following the prior week’s surprise expansion of Japan’s quantitative easing program to include global stocks and credit — were enough to overcome the negatives.

In fact, the situation is so good that instead of worrying about downside risks that seemed so threatening just a few weeks ago, there is concern now among investment professionals of being left behind. The need to chase top performing trades could be the impetus needed to fuel a traditional Santa Claus rally with all the trimmings this year.

Optimism is so rampant, it’s almost a negative: Bearish sentiment captured in polls is down to the lowest levels reached in the past 15 years. Sometimes in market history we have seen this kind of hopefulness at the start of big moves higher, while other such movements have been seen at the very end of advances.

Which is it this time? Well, none of the examples of downturns occurred, with three of the four major central banks in the world joining forces to effect a global reflation.

Furthermore, most investment managers are behind the eight ball. They dumped positions on the way down in mid-October and did not add them back fast enough on the way back up. This is a classic mistake, known as “cash drag,” and afflicts a lot more managers than you might imagine.

Here’s how many: Morningstar research shows that around 75 percent of large-cap value and large-cap growth funds are lagging their performance benchmarks, while around 87percent of mid-cap funds and about half of all small-cap funds are lagging.

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Think about that a second. Those managers’ bonuses, not to mention their jobs, depend on getting back in synch with their benchmarks, and there is only one way to do it.

Moreover, hedge funds aren’t exactly covering themselves in glory either: The Barclay Hedge Fund Index, which aggregates the performance of 943 funds, dropped 0.1 percent in October and is up just 2.9 percent for the year through October. The S&P 500 gained 2.4 percent in October and is now up 9.9 percent year-to-date. Even the equity long-biased subindex is lagging badly, up just 1.6 percent in October and 3.6 percent for the year through October.

This means that unless there is a highly motivating reason to avoid stocks, the big money is likely to pile into stocks that are on the move, including Apple (AAPL), Microsoft (MSFT), Yahoo! (YHOO), and Southwest Airlines (LUV).

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Japan’s dire straits and desperation move actually hold the key. The country’s pension fund, the GPIF, is expected to put fully half of its new global equity allocation to work in U.S. stocks. It is also expected to put half its new global fixed income allocation to the U.S. as well.

This is just like a bond and equity QE that might have been done by the Federal Reserve; it’s just a foreign central bank instead.

Analysts at Cornerstone Macro have pointed out that QE typically acts as an amplifier of an existing trend. The current trend in U.S. stocks is higher, so figure that the GPIF’s U.S. QE essentially acts like a bid under equities and bonds going forward; on every dip, it will be there. This should keep pressure on long-term yields as it pushes prices higher.

Now you might wonder whether the Japanese will be buying all stocks equally, and the answer is most likely not. Speaking very glibly, but from experience and study, Japanese fund managers tend to like well known, name-brand companies that they consider high quality. They tend to love luxury and technology brands. They tend not to be extremely price conscious.

So my speculation going forward is that the Japanese will have a tendency to buy the most famous high-quality tech and retail stocks with unchallenging valuations. On the tech side: Apple (AAPL), Google (GOOG), eBay (EBAY), Microsoft (MSFT), Facebook (FB), Intel (INTC), Cisco Systems (CSCO), Skyworks (SWKS) and Avago Tech (AVGO). On the retail side: Tiffany (TIF), Sotheby (BID), MarriottIntl (MAR), Hilton Hotels (HLT), Nordstrom (JWN), Whole Food Markets (WFM).

The interesting thing about this thesis is that some of these stocks are actually cheap, and liquid enough to buy in large quantity. Let’s say the GPIF decided to become a 5 percent owner of Apple, which is the Nasdaq stock with the highest market cap already. Its forward price/earnings multiple is only 12.7, or about even with its quarterly growth rate. Right now big-cap staples like Procter & Gamble (PG) and Coca-Cola (KO) sport PE multiples that are twice their growth rate, so figure Apple’s multiple could get to 18x to 24x.

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Figure that the buying pressure on Apple pushes its PE up 50 percent to 18x over the next year, which in turns pushes the Nasdaq up some fraction, let’s say 25 percent to 30 percent. In that event, there would be a lot of piling on, not to mention pushback from bears. So if you will just play along with this scenario, you could see the Nasdaq rise as high as 6,000 next year from its current perch around 4,600 — perhaps after a 2 percent to 4 percent dip first, just as a head fake to dampen sentiment a bit.

The S&P 500 would probably not fare quite so well under this scenario, since it is burdened by banking and energy stocks that would drag, so figure that in the bullish “global reflation” trade that includes serious inspiration from the GPIF, the S&P 500 advances, roughly 24 percent to 2,510. After that, all bets are off, as the election year 2016 could see a lot of the 2015 gains unwound.

If this does not happen, it will be more about central banks failing to reflate the Japanese and euro-zone economies than anything else, which will have more negative consequences than just a weak or stagnant stock market. We may scoff at the effort as manipulative and unworthy, but for the sake of citizens in those countries as well as ours, we should wish them the best and hope it works.

Best wishes,

Jon Markman