S&P 500: The bullish case for the next 12 to 18 months.
Gloomy headlines around recent economic data is raising a cause for concern.
Starting with the labor market, the unemployment rate is rising steadily since last summer. In the June payrolls report, the unemployment rate (bottom panel in the chart below) ticked higher to 4.1%. That’s the highest level since October 2021.
Even Federal Reserve Chair Jerome Powell commented that the labor market “has cooled really significantly” during remarks to Congress this past week.
The services sector of the economy might be showing cracks as well. The service sector has been a bright spot with pent up demand coming out of the pandemic.
But in the most recent report, the ISM non-manufacturing figure that tracks the service sector dropped to 48.8 for June. That’s the lowest level since May 2020, where a reading below 50 indicates contracting activity. The new orders and business activity subcomponents are turning lower as well as you can see in the chart below.
That’s making it easy to find dire news about the state of the economy and how the Fed’s restrictive monetary policy is finally starting to weigh.
But today, I want to offer a different take on the economy and stock market.
Outlooks are typically reserved for year end. But since we just passed the halfway point for 2024 and I see several bullish catalysts converging, I want to offer my view that the next 12 to 18 months could be surprisingly strong for the stock market.
Those converging forces include the liquidity cycle, corporate earnings growth, and stock market seasonality.
Here’s a quick breakdown of those three drivers that can keep the bull market humming over the next 12 to 18 months.
3 Bull Market Drivers
Liquidity Cycle
Liquidity is the lifeblood of asset prices, especially speculative ones like stocks and cryptocurrencies. I like to think about liquidity in a similar manner as financial conditions, which impacts the availability and cost of credit.
Plentiful liquidity can help promote looser financial conditions, which means that credit is readily available and at a low cost.
While many measures of financial conditions are already looser than historical averages, there are emerging signs that improving liquidity could deliver another positive boost.
That includes the year-over-year change in the M2 money supply. The M2 money supply is a broad measure of cash or instruments that can be quickly turned into cash in the U.S.
After surging in the wake of the pandemic, growth in M2 turned negative for the first time ever in 2022. The deceleration in growth and plunge into negative territory coincided with 2022’s bear market in the S&P 500. But a couple months ago, M2 growth turned back positive.
There are signs that the liquidity cycle is improving on a global scale, and not just in the U.S. The chart below comes from Capital Wars (via the Financial Times), who constructed a Global Liquidity Index that takes into account cash and credit across the global financial markets.
You can see in the chart that the global liquidity cycle is in the early stages of turning higher. Along with positive M2 growth, improving liquidity conditions on a global scale through next year can help boost asset prices including stocks.
Earnings Growth
Looser financial conditions are historically correlated with positive economic growth. And there are signs that the rate of change in both the economy and corporate earnings is improving.
You can see in the chart below that forward earnings estimates for the S&P 500 continue moving out to new highs. Positive revisions led forward earnings to new all-time highs in late 2023, which was well before the S&P 500 was breaking out to record highs.
And it’s not just in the U.S. Forward earnings estimates for various international regions including emerging markets, Europe, and Japan continue moving higher as well. And earnings across those regions can keep increasing given the evidence of rebounding economic activity.
The chart below looks at manufacturing purchasing managers’ indexes (PMI) from around the world. PMI’s are constructed so that a reading above 50 indicates expansion while below 50 shows contracting activity. The chart shows the percentage of PMI’s across 35 countries that are above 50, which is rebounding this year and recently stands at 60%.
Despite gloomy news that tends to dominate mainstream headlines, manufacturing activity is rebounding in major economies across the world. A synchronized boost in corporate earnings is another catalyst to keep pushing the bull market forward.
Decade Seasonality
Much is made about seasonal patterns intra-year, like months that tend to see pockets of strength or weakness. We also have common mantra’s like “sell in May and go away” or the “Santa Claus Rally.”
But zoom out, and you’ll notice seasonal patterns unfold across longer time frames as well.
The chart below traces the average movement of the Dow Jones Industrial Average by years ending with the same digit going all the way back to 1897. In other words, how did the Dow perform on average in years ending with 1, 2, 3, and so on.
And historically speaking, years ending with “5” rank as the best across the decade. More recent decades with years ending in “5” like 2015 and 2005 experienced sideways volatile trading and don’t really stand out. But 1995, 1985, and 1975 all produced large gains for the Dow.
I would not make trading or investment decisions based on seasonal patterns alone. But I do find the strong stock market seasonality in year “5” interesting given the liquidity cycle and earnings growth catalysts mentioned above.
Now What…
Last week, a cooler than expected inflation figure from the Consumer Price Index (CPI) sparked a massive rotation in the stock market.
Both headline and core CPI increased less than expected in June , which boosted speculation that rate cuts will happen soon. Odds for a 0.25% rate cut at the Federal Reserve’s September meeting now stand at 96%, with three rate cuts expected through year end.
The S&P 500 fell by 0.88% the day following the CPI data, with every member of the “Magnificent 7” trading lower. But the Russell 2000 Index of small-cap stocks ended the day 3.6% higher, showing strength in the average stock.
That same day, the ratio of advancing stocks relative to declining ones on the NYSE closed at 7.3/1, providing more evidence of broad participation under the hood. And the RSP exchange-traded fund that tracks an equal weight S&P 500 broke out from a consolidation pattern (chart below) that I first highlighted here.
In that same report, I discussed bullish signs that were emerging for the average stock, and I believe the follow through this week has very bullish implications for the outlook as well.
And while I believe more upside in the stock market could take many by surprise over the coming year, I’m certainly not suggesting it will be a smooth ride or straight shot higher.
The chart below offers a reminder that the second half of the year historically experiences a 10% drawdown in the S&P 500 despite seeing average gains overall. Even a strong first half where the S&P 500 returns over 10% (like we had this year) undergoes a 9% second half drawdown on average.
No matter what, my trading plan stays the same. I’m after stocks showing strong growth fundamentals that are setting up sound basing patterns with relative price strength.
That includes e.l.f. Beauty (ELF) which is forecast to grow earnings by 92% this year. Year-over-year sales growth for the past four quarters has ranged from 71% to 85%. And the stock has been creating a new basing pattern (chart below) since the start of March after hitting the $220 level. The stock is recently testing that level again and now making a smaller pullback. That’s resetting the MACD at the zero line while the relative strength line remains near the high. I’m now watching for a move over $220.
That’s all for this week. With key inflation reports out of the way, investor attention will now turn to corporate earnings. The first batch of major bank earnings already started, and the pace of earnings season will pick up with 45 of the S&P 500 reporting this coming week. I’ll be watching how forward earnings estimates keep evolving, and if the average stock can keep building on last week’s strong performance.
I hope you’ve enjoyed The Market Mosaic, and please share this report with your family, friends, coworkers…or anyone that would benefit from an objective look at the stock market.
For updated charts, market analysis, and other trade ideas, you can visit me here: www.mosaicassetco.com
Disclaimer: these are not recommendations and just my thoughts and opinions…do your own due diligence! I may hold a position in the securities mentioned in this report.
