Is this Rally Real?

Dave Dyer

If you are one of the millions of people who stayed on the sidelines during the recent rally, you probably are wondering whether or not this sudden move is real. Some people think it is a temporary head fake bound to collapse, while others think it is the start of a longer term trend. We think there are compelling reasons to be confident and optimistic about the direction of the U.S. stock market.

It helps to understand the fundamental factors that move the markets, and nothing is more fundamental than supply and demand. In any market, these are the main factors in determining prices. In the stock market, the supply is the amount of stock in public companies that is currently available for trading and the demand is the money that investors intend to use to buy those stocks. Supply changes when new listings bring more stock to the market and bankruptcies and mergers take stock out of the market. Demand changes with fluctuations in the money supply and the intentions of the investors.

So, where is the money now and why might it flow into stocks? If you can predict where the new demand will be, you should feel more confident about investing.

I see four sources of money that could move into the market.

1. Money on the sidelines owned by American investors. Cautious investors like you have retained their savings. Caution is actually a good sign for the market because this money can come in quickly if investors become more optimistic. Where is this money likely to go? If retail investors have not been comfortable with the market recently, they may venture in with conservative large-cap American stocks. They are more likely to invest in ETFs that represent a major index and less likely to research individual smaller companies.

2. Money owned by foreign investors. Slow growth and low interest rates in many countries have left foreign investors with fewer good options. America has always had the most innovative companies available in highly transparent markets. Foreign money is welcome in our markets and, as our renewed economic growth becomes more apparent, more of that money should flow in. They probably will favor internationally recognized names among big cap stocks but they may also pursue ownership of American real estate assets.

3. Profits of American corporations trapped overseas by tax laws. American corporations have about $2 trillion in profits that are currently stored in foreign accounts. Under current tax laws, this money would be heavily taxed if it is brought back into our country, but the Trump administration intends to change this. If some or all of this money returns, it could be used to pay down debt, increase dividends, buy back stock, and invest in research and development. All of these should be good for the price of stocks. If the tax laws change, look for the shares of American multi-national companies to improve.

4. Money invested in fixed rate bonds. Finally, there is a huge amount of money, around $14 trillion, that has been invested in safe but low interest US treasuries. As long as interest rates were declining, treasuries were good investments. However, when rates start going up, new treasuries that pay higher rates will be available and the value of the current ones will decline. As these investors start losing money for the first time in 35 years, they should seek bond replacements with decent yields like utilities, REITs, master limited partnerships, and business development companies.

These are four sources of fuel to keep the market going. But, investors still need the motivation to add the fuel to the fire. That motivation comes from improving economic conditions in an environment of low, but increasing, interest rates and optimism about lower taxes and more business-friendly regulations. Even if interest rates go up a bit, they are still low by historical standards. As recently as 2007, the Federal Reserve was lending money overnight at 5.25%; the current rate is 0.5% to 0.75%. Consumer confidence surveys have shown improvement, and actual consumer spending increased as a confirmation of that data. The unemployment rate is improving and the inflation rate is approaching the 2% range that the Fed desires.

The stock market advance has included a wide range of sectors, including financials, steel, energy, technology, utilities, transportation, and healthcare. Earnings have improved in many sectors. This is a good sign because it shows that there is not just one hot sector that could be vulnerable to a sudden collapse.

In addition to these considerations, we can find a lot of reality in the leading companies compared with former boom times. Back in 1999, a company with a name and an idea but no sales could go up dramatically. And most of you will recall 2008 when home values soared even though owners could not afford to pay their mortgages. Compared to those times, today’s market is very real and not based on smoke and mirrors. Apple, Amazon, Google, and Facebook all have real businesses with real profits and real growth.

There is a lot a fuel available and investors have some good reasons to add it to the fire. These conditions should support a longer term advance for the markets.