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The Smart Way to Be a Cautious Bull

3 | By Shah Gilani

As a long-term investor, I’m a raging bull. I expect the markets to double in the next five years.

However, as a trader, I’m cautious up here and I’m skeptical of the new record highs stocks just made.

There’s a dozen reasons that point to markets continuing to climb for several more years. But markets don’t go up in a straight line, though they can have long upswings lasting years.

We just made new all-time highs again in this post-Irma “relief rally”, so it’s the perfect time to check to see whether there are any serious impediments to going a lot higher in the short haul.

Here’s the base case for stocks doubling in the long-term, and how to survive the short-term pitfalls in front of us…

The Big Dow Double Down

The bull market case isn’t just academic, it’s positively fundamental.

Since 1998, the number of listed companies on U.S. exchanges has been cut in half. Since just 2007, the surviving listed companies have bought back more than seven trillion dollars’ worth of their own shares, further reducing total shares outstanding.

Because of share buybacks, mergers, acquisitions, leveraged buyouts, industry consolidation, ever larger economies of scale, companies not splitting their shares, the passive investing trend where stocks aren’t traded but warehoused, and the complete dearth of IPOs, there will be fewer and fewer shares in the open market for investors to buy.

At the same time, there’s more and more capital being created every day.

Besides the tens of trillions of dollars printed globally by central banks over the past 10 years, the market being up more than 260% since 2009 is a source of reinvestment capital scooping up more shares. New money in the form of net profits, globally, is being parked in stocks.

More capital chasing fewer shares is an easy equation to understand. Being bullish is a no-brainer.

Unfortunately, it’s not that simple.

I’m a cautious bull up here. There are few potential pitfalls we need to leapfrog, and we need to know how.

How to Handle the Hurdles

If we can’t swerve past these roadblocks, I want to have stops down on all my positions and step aside if any significant profit taking turns into a more serious rout.

Stocks are expensive by almost every historical measure analysts look at. Valuation alone isn’t what moves stocks, but it is important when the crowd is nervous about “overvalued” stocks.

Earnings have been a positive over the past few quarters, with the second quarter seeing more than 10% growth in earnings for the S&P 500. But a lot of that robust earnings growth in the first and second quarters of this year was enhanced by a 10% drop in the U.S. dollar. If the dollar firms up, that earnings helping hand will flatline.

If interest rates tick up, the dollar will firm and that might end the earnings run.

While it’s unlikely that interest rates will be driven a lot higher by the Federal Reserve, any uptick in rates could impact earnings. Based on Fed Fund’s futures, the Federal Reserve isn’t likely to stick to their pronouncements about raising rates a few times this year. But they are still jawboning their intention to start unwinding their balance sheet that holds more than $4 trillion of Treasuries and other securities.

Not replacing balance sheet holdings that mature and “run off” means the Fed won’t be active buyers in the open market, which could cause rates to tick up as other buyers demand more interest to lend money to the government.

The reason the Fed’s unlikely to raise rates in December for next expected to move is that no one knows yet what the cost will be to clean up after Harvey and Irma. And the last thing the Fed wants to do is put upward pressure on rates at the same time funds will desperately be needed for rebuilding.

Still, with the economy showing signs of growth, if there’s money available for clean-up and rebuilding in Texas and Florida then interest rates could start ticking up as demand for money spreads across the economy.

Markets are nervous about the impact of Fed rate hike policies and the great balance sheet unwind, and they’re nervous about long term impacts on economic growth from the costs associated with Harvey and Irma.

If the relief rally that markets have enjoyed can’t be sustained, meaning there’s no consolidation up at new highs and no new buying, stocks will be prone to slipping backwards.

21,500 is an extremely important support level for the Dow. If the Industrial Average can stay away from that lower level, there’s a good chance we might have another solid leg up.

However, if stocks slip on the heels of the latest push up, everyone will be focused on Harvey and Irma’s impacts, on interest rates, on the dollar, and on earnings. And if these pitfalls look like they’re weakening the ground the market’s climbed up lately, there’s going to be another kind of storm.

Be careful out there.

Sincerely,

Shah

3 Responses to The Smart Way to Be a Cautious Bull

  1. randy a says:

    You expect the market to double in the next 5 years? I expect the market to be cut in half within the next 5 years. I could be wrong. GOD ALMIGHTY HIMSELF COULD NOT SINK THIS MARKET! In the end You put your money down & you take your chance

  2. Maggie Moo. says:

    Mr. Gilani,
    You write really well and your explanations are helpful, targeted, clear and simple. The Kar-Ma of Har-Ma hit Houston where my fellow RWA writers have their National offices… and I wonder “i.f.” the Resort where you a.r.e. planning an event was totaled in the squall? Meanwhile, I studied my options. And I would like to express my appreciation for the education that you gave us regarding APRN. Just by studying the “premise” of that trade from top to bottom and bottom to top… plus doing the math and trading i.t. in my mind and on paper… I was able to pass my level 0 and 1 options inquisition within one month. I really wish to thank you for that well designed example and tutorial trade. I am a cautious bull. And I would like to learn more. 1001 thanks!

  3. Scott says:

    Given the amount of cash out there, is the Fed unwinding that big of a deal going forward? The 7 trillion you mention in stock buybacks alone may have been reduced significantly had investors had better options in the fixed income markets (ie government bonds) as companies may not have been issuing such a massive amount of corporate bonds to fund the buybacks…we wouldn’t have such elevated stock prices and a Fed without $4 Trillion of securities

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