ETN Eaton Corp New

Adding substance to optimistic predictions

As investors swallowed a bunch of nauseating economic data this week, we were also treated to a fresh dose of optimism in the form of one Mr. James Altucher and his “Dow 20,000” prediction. Writing for MarketWatch, Altucher outlined ten reasons why the market will soar in the next 12 to 18 months, boosting the S&P 500 to 2,000 along the way.

Many of his arguments were similar to those I wrote in a piece for TheStreet in May, “8 Reasons the S&P 500 is Going to 1,500.” And that piece was based on an article I wrote for The Options News Network in March of 2010, “7 Reasons the S&P 500 is Going to 1,300.”

While I agree with Altucher on several points -- and more importantly on the overall theme of an extended bull market and economic good times for the next few years -- I also want to highlight where a few of them do little to support a 50% rise in the broad averages before 2014. In other words, it’s a great start with lots of potential. And probably more meaningful for investors now than that “Dow 36K” book written a decade ago.

Where We Agree

In my original analysis from 15 months ago, the accelerated earnings recovery was my #2 reason for continued bullishness. Altucher cites corporate profits at record levels as his #7. Obviously, we mean the same thing. In my amateur-economist penchant for finding memorable ways to describe markets, I began calling the forces driving the 2009 market launch “the V-Recovery Spread.”

What I was attempting to capture in this phrase was the fact that off of a recession trough, institutional fund managers would aggressively buy stocks as earnings recovered faster than P/E multiples. In short, they were buying the spread of trough earnings to close the gap with extended valuations.

When most doubted the “V-recovery” thesis in 2009, I explained why it was actually working, especially with Steady Ben at the helm of the Fed. When I recently became a student of the Zacks Rank stock rating system and related investing methodologies, I discovered the underlying mechanics of why it worked.

Altucher and I also both tout cash on the sidelines. When I wrote in March of 2010, I was talking about $1 trillion on non-financial balance sheets. That number has doubled as I noted last month when I said, “cash on the sidelines is massive -- and still trash -- in the era of extended QE.”

But I’m not just talking about the $2 trillion on corporate balance sheets. I’m talking about the staggering bond fund inflows that dwarfed equity fund inflows throughout 2009 and 2010 -- after the credit crisis was over. According to data I just dug up from the Investment Company Institute, in that two years, bond mutual funds, both taxable and municipal, attracted $617.3 billion of inflows versus equity mutual funds at minus $45.5 billion in net outflow! With those kind of numbers, it’s a wonder the stock market went up at all.

Altucher gives two of his ten reasons to “innovation” and “dirt cheap” stocks. I don’t talk directly about innovation in my 8 reasons, but I have always been a big fan of this perpetual force of motion in the American economy. It’s what makes us the most dynamic and thriving economy on the planet. Technology and productivity beget more of both and certainly add to GDP and profits in ways I’m not qualified to talk about.

Regarding cheap stocks like Apple (AAPL) and Microsoft (MSFT), I also agree strongly. He cites Apple trading for 12 times forward earnings when you back out the $65 billion in cash it has with no debt. I think the stock is a buy here not simply for its earnings momentum but also its must-have gadget magic and productivity tools that create cult-like consumer momentum.

My boss here, Steve Reitmeister, believes that Apple’s biggest victories may be on the horizon as consumers who keep moving up the product cycle—from iPod, to iPhone, to MacBook, as I just did—will be more likely to buy an Apple desktop next. With single digit desktop market share now, imagine the possibilities for the company’s revenue and earnings if they double their penetration.

Where We Part Company

Altucher opens with his #1 reason for Dow 20K as “QE2 has not started.” He’s being clever, of course, but then his logic is utterly flawed. He cites the old monetary policy tenet that “Federal stimulus takes 6 to 18 months before even one dollar hits the U.S. economy in a meaningful way.”

Talk about getting your apples and oranges mixed up. QE2 was a bond buying market operation with immediate impact on yields and capital flows. He somehow thinks we should “expect that $600 billion or more to start hitting toward the end of 2011.” Ask any economist and he or she will tell you that the QE2 string-pushing was so January.

The remaining reasons for Dow 20K are a little hazy, if not underwhelming. His #3 reason is the “multiplier effect.” Isn’t this part of the Fed stimulus argument? And #6 on the employment picture is a solid idea in of itself. But I’m not sure it belongs on a list like this. Yes, temp worker hiring increases are historically indicative of an encouraging jobs outlook down the road. But it’s still part of any slow grind recovery and not a catalyst for excess returns.

What got left out may be more important than anything. What’s driving the stock market recovery—as much as, if not more than, any extraordinary monetary policy— is emerging markets. Global growth and demand from dozens of countries with emerging middle class populations that want the lifestyles of the west have kept the profits of companies like Caterpillar (CAT) and Eaton (ETN) brimming as infrastructure development in the BRICs and beyond hiccupped during the US banking crisis and then forged on.

And he closes with a curious reference to “major demographic changes… that are going to affect stocks for the next 25 years.” Not only does he not tell us what any of these changes are, he doesn’t explain what the next 25 years has to do with his prediction for the next 18 months.

Finally, James wraps up with a “see, I told you so” thumbed nose to all his critics the last time he rolled out a similar wild prediction. I feel his pain, especially the part about his kids “Googling” their last name to find post after post insulting their Dad. Refreshingly for them, he was vindicated for his last predictions with a market 25% higher. I went through something similar in the spring of 2010 after my call for S&P 1,300—right before Deepwater Horizon and the “flash crash.”

My criticism of his work is with all due respect and more. I am bullish on America too and I love big, macro, amateur-economist think pieces like this. Because I would actually rather discuss the economy and our country’s future with someone like him than any economist on Wall Street. Good data and research are essential for stock-picking as we prove here every week at Zacks, but vision and analysis often make the big difference in long run investing success.

And you don’t need a PhD in economics to figure out what the big trends driving growth for the next few years will be. If you’re not sure where to begin, just ask James or I. We’ll share all our nearly-expert analysis.
Kevin Cook is a Senior Stock Strategist for Zacks.com
 
APPLE INC (AAPL): Free Stock Analysis Report
 
CATERPILLAR INC (CAT): Free Stock Analysis Report
 
EATON CORP (ETN): Free Stock Analysis Report
 
MICROSOFT CORP (MSFT): Free Stock Analysis Report
 
Zacks Investment Research