How Much Higher Can The Stock Market Go From Here?

How Much Higher Can The Stock Market Go From Here?

Amid a staggered global economic recovery from COVID-19, nearly every day feels like a constant barrage of negative headlines. And yet the stock market continues to ignore the news and hit record all-time highs.

• US withdrawals from Afghanistan in a disorderly fashion? New record stock market high.

• Rising cases of COVID-19 Delta variant? New record stock market high.

• Big miss on quarterly GDP data? New record stock market high.

As of August 16, the S&P 500 has notched 49 record closing highs in 2021, the most since 2017 and within reach of the record 78 seen in 1995.

This scenario has left many wondering: how much higher can the stock market go from here?

A lot higher, in my opinion, for three key reasons.

First, investor sentiment is nowhere near the levels often seen as a contrarian sell indicator. When everyone and their mother turns bullish on stocks, it has historically paid to take the opposite side of that bet.

But the euphoria you’d expect to see sweep over investors amid a non-stop rally in stocks is nowhere to be found.

Instead, there have been rolling pockets of euphoria in certain areas of the market, like SPAC mergers, GameStop/AMC, and cryptocurrencies. But it’s been well-contained euphoria that has yet to spill over into the broader market.

Several stock market sentiment indicators are instead showing signs of persistent fear among investors.

There’s still a large group of investors that don’t believe in the current rally, meaning ongoing buying pressure could drive stocks higher as the market slowly turns skeptics into believers.

Second, corporate profits, often viewed as the biggest driver of stock prices, are soaring. With more than 90% of S&P 500 companies having already reported second quarter earnings, 87% of them beat analyst’s revenue and profit estimates, according to FactSet.

S&P 500 revenue growth is up 25% in the second quarter, well above the 10-year average growth rate of 3.4%. Profit growth is up 89%, representing the fastest growth since 2009.

Analysts already expected revenue and profit growth to be strong in the second quarter due to the weak year-over-year pandemic comparisons, but not this strong. Now they’re raising their estimates, which is constructive for stock prices.

Pent-up demand from consumers, combined with companies’ ability to raise prices, should drive continued strength in revenue and profit growth in the intermediate term.

And rising profits should lead to a boom in corporate share buybacks, which were largely abandoned amid the uncertainty of the pandemic. Buybacks represent yet another lever for higher stock prices, with JPMorgan suggesting a record $1 trillion in buybacks could hit the market next year.

With the post-COVID economic expansion barely one year old, a multi-year tailwind for corporate profits should be in order, given that since 1945, economic expansions have lasted five years on average, with the record being nearly 11 years (2009 – 2020).

Third, accommodative policy from the Federal Reserve and Congress will likely linger a lot longer than most people think. There are still 8 million fewer Americans employed today than before the pandemic, and the possibility for a continued mutation in COVID variants is leaving policy makers on edge.

The Fed has indicated that it won’t begin to raise interest rates until 2023, though its monthly bond purchases will likely begin to scale back by year-end.

The Fed’s slow and methodical approach conveys the fact that the last thing they want to do is press the brakes on a growing economy too early. They’d rather be certain that the economy is on strong footing before they send borrowing costs higher.

Meanwhile, Congress is on the verge of passing a bipartisan $1 trillion infrastructure bill, and the Biden administration has indicated more spending programs will follow.

“Stocks can’t go up forever… the market is bound to crash eventually,” skeptical investors say.

But considering subdued investor sentiment, higher corporate profits, and accommodative monetary and fiscal policy, the bigger risk may not be owning stocks in the short-term, but rather not owning enough stocks for the long-term.

The Risks

Despite the optimistic view outlined above, there are still risks in the stock market that could lead to at least a 15% sell-off at any time. What risk(s) could drive the next sell-off?

A rise in COVID-19 cases caused by the fast-spreading delta variant have yet to put a dent into markets, but that could change if lockdown measures return during the colder months (especially if schools go back to virtual).

Or, if COVID-19 lingers a lot longer (years) than people expect and turns into an endemic, the economy (and stock market) could enter a malaise.

Higher inflation could (already is?) scare investors, but supply chain imbalances will ultimately be worked out, and ongoing innovations in technology should continue to put negative pressure on prices and tame inflation.

Even if a prolonged period of inflation does materialize, you want to own real assets, like stocks, because businesses can quickly raise their prices and generate returns that far outpace the rate of inflation.

A hawkish Fed that raises interest rates quicker than expected in response to inflation is possible, but it’s worth noting that stocks performed well during the last cycle of interest rate hikes in 2017 and 2018.

Lofty valuations have been seen as a worrying sign that stocks will peak soon, but swift earnings growth is beginning to make valuations more reasonable, especially when you consider the nearzero interest rate environment aka "there is no alternative."

The S&P 500’s forward 12-month price-to-earnings ratio currently stands at 21x, well below its recent high of 24x, and just above its 5-year average of 18.2x. Overvalued? Sure. But is the premium justified given the strong earnings results and outlook? I think so.

Whatever drives the next sell-off, remember that on average since 1980, the stock market has experienced a 14% sell-off every single year. And yet it still paid to own stocks during that volatility, as the S&P 500 went on to return an average 9% per year.

Corrections are a healthy, necessary part of markets that help build the base for further gains in the long run. If gains in the stock market is the ticket, then risk is the price of that ticket. You can’t have one without the other.

Mentally preparing yourself for the next correction will go a long way in preventing emotional panic selling that tends to occur at the worst possible time, because while holding stocks through the good and the bad is hard, timing the market is even harder.

But knowing that you own high quality, growing, brand name companies (that you may even be a loyal customer of) should help dampen the psychological effect of your portfolio’s next drawdown, regardless of what the headlines are.

Second Quarter Review

Go to google and search: “interest rates cartoon Mankoff”

I can’t include here because of copyright laws, but the cartoon shows a person watching TV news, with the anchor saying:

This cartoon perfectly sums up what transpired in the markets over the past few months. So good in fact, I have little else to add. Interest rate volatility drove various market narratives including runaway inflation, sluggish economic growth, an overheating economy, to everything in between.

As amazingly accurate as the cartoon is in describing the ongoings in the stock market, what’s more amazing is that this cartoon appeared in The New Yorker in the 1980’s. When it comes to human psychology and money, nothing changes.