The Virtuous Cycle

In a recent survey by the National Association of Business Economics, 70% of economists said they believe the U.S. economy will grow by more than 2%. Just three months ago, only 61% of surveyed economists had such bullish expectations.   

And it gets better. 24% of surveyed economists believe 3% growth is coming, up from just 14% January.   

The details of the survey also show that employment is improving in the hardest-hit sectors: real estate, finance and manufacturing. And salaries are also on the rise.   

Heavy equipment maker Caterpillar (NYSE:CAT), a bellwether for global economic conditions, reported solid earnings this morning. And it raised full-year 2010 earnings projections, saying that “…economic conditions are definitely improving…”   

The stock market is certainly acting as though better times are ahead. Still, it seems that individual investors remain skeptical.   

Caterpillar’s comments point to the reason why: much of the growth in orders it is seeing is coming from outside the U.S. Caterpillar actually lowered its estimate of housing starts in the U.S. by 20%, from 1 million to 800,000. It said the weak labor market was "the major reason many remain pessimistic about the U.S. economy." 

I suspect that fact is what’s weighing on investors right now. How can the economy improve if unemployment remains stuck? And how can the stock market hold onto to its gains if consumer spending is capped by the unemployed?

Stock prices are forward-looking. That means that current valuations are not solely based on the current business environment, but rather, on what investors expect in the future.   

Over the past few quarters, corporate earnings have beaten estimates handily. Around 80% of companies are beating estimates for 1st quarter 2010. That’s phenomenal. And the current rally reflects the likelihood that earnings growth will continue into the future.   

Companies have clearly cut their expenses to the point that current spending from both consumers and businesses is having a big impact on profits. What’s more, companies haven’t had to take on more expenses to grow profits at a healthy pace.   

I think that we’re at the outset of a virtuous cycle, where increased demand leads to increased employment which leads to increased demand…  

Mutual fund inflows continued to grow in the 1^st quarter. In fact, investors added as much money between January and March 2010 as they did at the market’s bottom in March 2009.   

But most of the $123 billion in fund inflows went to bond funds. Equity funds only attracted $15 billion in new funds. That’s less than half the $35 billion in net new funds that went into bond funds.   

Again, investors’ behavior suggests they remain skeptical and prefer the relative safety of bonds.  

Now, skepticism is almost a pre-requisite for strong bull market. And this particular bull run has no shortage of strength or skeptics.   

According to Ned Davis research, 90% of stocks are trading above their 50-day moving average. That’s triggered a “breadth thrust buy signal.”   

Apparently there have only been 12 breadth thrust buy signal since 1967. 2 occurred in the last year. And this particular buy signal seems very robust.  

In the ensuing month, the S&P 500 has averaged a 4.6% gain. In the following quarter, the gain is 8.2%. And the gains for the entire year following a “breadth thrust buy signal” have averaged 19.7%. What’s more, from the research presented, there has never been a loss for the S&P 500 in the 12 months following this buy signal.   

Maybe it’s time to drop the skepticism…