There Are Green Lights All Over the Place for U.S. Stock Bulls

(Bloomberg) -- Forget Wall Street’s complex models, and consider the simple logic powering stock investors right now.

The Federal Reserve’s projected easing cycle looks poised to kick in against a backdrop of billions in cash on the sidelines, low volatility and a real economy on an even keel. All are signposts that the bull run still has juice.

With trade fears dimming for now, equities still look appealing as the return offered by Treasuries declines and a steady corporate bond market boosts confidence in the outlook for earnings. Even after stocks hit multiple records in recent weeks, the S&P 500’s earnings yield remains well above its average versus that of 10-year Treasuries.

Throw in positioning data that shows investors have ample room to up their allocations, and the bull case grows stronger.

“Right now the Fed is cutting when growth prospects are nowhere near weak and Fed funds is close to neutral,” Tom Porcelli, chief U.S. economist at RBC Capital Markets, wrote in a recent note. “Risk assets should absolutely love this setup.”

Assuming easier policy does come, it will be at a potentially propitious time for equities. Retail sales figures last week beat forecasts, adding to positive surprises of late. For Neil Dutta, head of economics at Renaissance Macro Research, it’s a sign estimates are out of step and will need to be revised higher.

“Imagine that,” he wrote in a note to clients. “The Fed is cutting as growth and earnings estimates turn up. Cyclicals anyone?”

Even as the U.S. central bank seeks to enact a preemptive rate cut, there are few worries about the economic outlook on display in the credit market. The cost to insure high-grade debt against default for five years remains near the lowest in more than a year.

The Bank of America survey, for one, shows that more investors are making peace with the rally. Money managers said they added risk in July, rotating into the likes of industrials and banks.

Meanwhile, the Cboe Volatility Index, a measure of U.S. stock volatility known as the VIX, remains below one- and five-year averages. And traders remain net short futures on the gauge as they bet price swings will remain subdued.

Bespoke Investment Group says earnings seasons that start with the VIX below 13 have seen stocks gain an average 1.1% since 2001. For earnings seasons when the VIX starts above 13, there is an average decline of 0.3%.

And then there are earnings themselves. For JPMorgan Chase & Co., “the results so far, even though it is admittedly still very early in the season, are quite encouraging.” With slightly more than 10% of S&P 500 companies reporting, 5% have delivered positive surprises.

Misses aren’t being heavily punished, either. The market may be looking through bad results thanks to the trade war truce and expected rate cut, according to Wells Fargo strategists led by Christopher Harvey. “Though it’s a small sample size, EPS misses recovered 50% of their initial one-day underperformance over the following five days,” they wrote on Monday.

That’s not to say bulls have the all-clear. After a 17% gain for the S&P 500 Index in the first half, there’s plenty of caution on display.

Goldman Sachs Group Inc., for one, sees little upside from here, reckoning the S&P 500 is trading near its fair value relative to interest rates, profitability and price-to-book value. UBS Group AG is also skeptical.

“While we expect modest upside for stocks in our base case, valuations and corporate fundamentals don’t point to a ‘melt-up,’” said Mark Haefele, chief investment officer at UBS Global Wealth.

Among hedge funds focused only on equities, a more promising view is emerging, however. They have begun to slightly boost their exposure to U.S. stocks, judging by the portion of their returns attributable to the benchmark, a measure known as beta. In fact, overall positioning is another tailwind, reckon Macro Risk Advisors.

“We note that broad equity market positioning is currently at a ‘goldilocks’ level in that it does not appear too stretched,” strategist Max Grinacoff wrote in a note last week.

That leaves plenty of room for others to join in, including the investors who have piled some $3.25 trillion into money market funds, according to ICI data. As returns decline with rates, they may prefer to put the cash to work. The Bank of America survey showed cash levels fell from a month earlier.

Those allocations remain above average, however, amid a host of lingering worries.

“Expectations of an earnings recession and debt deflation still dominate sentiment,” Michael Hartnett, chief investment strategist at Bank of America, wrote alongside the survey results. “The pain trade for the summer remains up in stocks and yields.”

--With assistance from Cecile Gutscher, Luke Kawa and Brendan Walsh.

To contact the reporter on this story: Samuel Potter in London at spotter33@bloomberg.net

To contact the editors responsible for this story: Samuel Potter at spotter33@bloomberg.net, Sid Verma, Yakob Peterseil

©2019 Bloomberg L.P.