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Why I’m Still Bullish on the Chinese Economy

Recent news from China about slowing growth and exports, the depreciation of the renminbi, and volatility in the stock market, has painted a pretty gloomy picture.

But from my vantage point here in China, I take a more positive view toward the country’s economic situation. The progress that private companies are making, and the success of many firms at selling to China’s rapidly rising middle class, are just two of the reasons why I remain positive toward China’s economic prospects.

In this post I focus on why I continue to feel broadly positive about the economy, and what are the four trends that business leaders should pay close attention to. In a follow-up post, I will cover some of the risks that could throw the economy off course, if not handled well.

Why I remain positive

China’s actual and potential growth path has slowed considerably, but it is still a US$10 trillion economy, and it is growing faster than most of the world’s top 20 economies.  This growth is mainly driven by consumer spending and is spending that increasingly goes toward services and not products.

Chinese consumers still feel confident and are spending to reflect that.  Chinese consumers feel secure in their jobs (with over 7 million new urban jobs in China year-to-date) and have rising incomes (up 8% over the last year). Much of China’s wealth is concentrated in the younger generation who see much less reason to save than their parents did, and for whom paying for a service that saves them valuable time is a trade-off worth making.

Not only are they willing to spend, but they also don’t really see good options for investing. The stock market is a lottery, property investments are generally not rising in value, and banks offer negligible interest rates. Spending seems a pretty good alternative to saving.  These consumers have over US$9 trillion in financial savings today, according to JP Morgan.  The potential for them to spend more in the years ahead is already in place.

While China’s manufacturing sector has grabbed our attention, China’s service sector has quietly been powering ahead with the Purchasing Managers’ Index at 54-55 (anything over 50 indicates an expansion in purchase of services).  This year will likely be the first on record in which services represents more than 50% of GDP (up from 46% only 2 years ago).

This is not just about Internet enabled services, such as e-retail and taxis.  Very traditional service sectors are growing fast.  Take cinemas for example – box office revenues in the first half of 2015 rose almost 50%, the turnover of second hand car dealers rose over 30%, rail travel was up by over 10%.

Services that were almost non-existent in the past such as elderly care and vocational retraining are becoming job creation engines.  Foreign investors should pay close attention to the opportunities in services as the majority are fully open to international investors.

On more specific issues:

+ Currency – we had similar scale adjustments in the past, and certainly the trade weighted exchange rate is still stronger than a year ago.

+ Equity – the market is still up 30% year-on-year.

+ Capital outflows from China have been much larger as a % of GDP in the past.

+ Housing sales have been up for the last two quarters.

Four trends that matter in China today

There’s lots of noise in the system, but where are the real underlying signals? Let’s take a look at four trends that are shaping the economic landscape in China today:

Trend #1: Consumers have money and are increasingly willing to spend it.

China’s middle class feels secure in their jobs today after a decade of rapid income growth and widespread availability of opportunities. Consumer confidence is closer to 110 than 100 on most surveys, consumption growth was higher in Q2 than Q1 of this year with real disposable income up 8% year to date, and spending rose 10%.

So China’s middle class is finally spending more and saving a little less.  Yet there is a long way to go – consumption is still only 37% of GDP in China versus 60% India and 70% in the USA.

There are several reasons for this shift. Most Chinese middle class own their own home and car now.  They don’t need to save for these lumpy purchases.  And the generation that is 25-35, where most of the wealth resides, has never known a recession. The experiences of their parents and grandparents of needing to save for bad times is just a history lesson to them, not personal experience.

And with the stock market looking less attractive, good investment options are scarce, so why not spend a little more.  With over US$9 trillion in the bank, according to JP Morgan, Chinese consumers certainly have the firepower to drive the economy forward.

With over US$9 trillion in the bank, according to JP Morgan, Chinese consumers certainly have the firepower to drive the economy forward.

Trend #2: Consumer spending is shifting to services, and could grow a lot faster if supply issues were fixed.

The service sector’s share of the economy is rising fast, from 46% in 2013 to 50% this year.  Unsurprisingly, the Purchasing Managers’ Index (PMI) has held at 54-55 pretty consistently over the last 4 years (over 50 indicates growth in purchase of services). Sector value rose 8.4% in Q2, employment rose 5-6%, and investment was up 11%.  All good numbers, but they could be much higher.

As Chinese consumers place a greater value on their time, they are seeking better quality services to free up time for what they really want to do -and they are willing to pay for them. Consumers have historically held back from spending on services not only because they wanted to save, but also because what was on offer was not really worth spending on:

+ Lack of access to services. Many services just were not even available, like elderly care and credit services to start-up businesses.  The same has been true in healthcare and education.  Outside of the big cities, options were very limited.

+ Poor quality of services. Even where services have been available, they have been poor.  Traditional banking services and healthcare services took hours of a consumer’s time. Consumers are often forced to feel that they are lucky to get any service at all.  And if you look on sport as an entertainment service, the quality of sports like soccer lagged far behind other much smaller Asian economies.

+ Inefficient and high cost. A third reason not to spend on services is that they are expensive and inefficiently delivered.  Service sector productivity in services is only about one-third that of the OECD average.  Logistics, for example, consumes 18% of GDP in China versus 7% in the US.

A totally realistic set of improvements to China’s service sector could easily add $2 trillion to China’s GDP by 2025. The good news is that the private sector is investing to deliver better services.  Some are going overseas to acquire skills – for example, Wanda just bought the world’s leading organizer of triathlon events.

Chinese theme park companies are closely observing the development of Disney in Shanghai to learn how to upgrade their performance.  The explosion of Internet enabled services from banking, to retail, to transportation and healthcare, is transforming sectors within only a few months.

A totally realistic set of improvements to China’s service sector could easily add $2 trillion to China’s GDP by 2025.

But it isn’t all Internet driven, for example:

+ Second-hand car sales in July saw value up 33% and volume up 40% over last year.

+ After lots of investment, cinemas are now offering a great product and service. Consumers are willing to pay up to US$20 a ticket. In the first half of 2015, ticket sales were up nearly 50%.

+ Even passenger rail revenues are up 8% and air passengers are up 11% in recent months.

Trend #3: Capital is substituting for labor almost everywhere, except in government.

With slower growth, greater efficiency has become the priority across all businesses.  CEOs tend not to be looking to borrow more, or to invest more (overcapacity is common), nor are they looking to hire more.  The message to management is how we get more from what we have.  There is a lot of low-hanging fruit.

Energy for example has been treated almost as a free resource by many state-owned enterprises.  I have seen simple energy audits that lead to a 20-30% reduction in energy consumption within 3 months.

Production lines look very different than a few years ago.  Not no people, not full automation, but an intelligent combination of automation and higher skilled labor.

In services, we are just starting to see the impact of investments made in the sector on employment – how many bank branches will be needed when banking is largely conducted online, how many insurance agents will be needed when insurance is largely sold online; certainly not the millions that exist today.

The result is a much more dramatic separation of winners and losers in many sectors. Winners execute in world-class fashion on this drive to greater efficiency; they embrace opportunities to innovate; and are ready to challenge more internationally. Losers fall back on the traditional request for government support and protection.

However, the government is lagging in applying these experiences to itself. In a country where citizens are willing to do almost anything online to save time, money and get better service – interaction with government is a series of time-consuming battles.  A more efficient option, if offered at all, is only available to those willing to pay a massive premium.

It is important for its credibility that government applies technology to its own services.  Being able to make a doctor reservation online is good, but is essentially a private sector provided service. What about all the license renewals and fee payments that citizens have to make?

Running China is becoming much more expensive even though teachers, doctors, civil servants, security forces remain underpaid relative to their private sector peers.  The impact can be seen in fewer students taking civil service exams, and fewer of the best students joining government.  For a government less cash rich and more talent hungry, this is a growing problem.

Trend #4: Property is holding steady.

Despite what you might have inferred from some press articles, construction will remain a pillar industry in China. The need to upgrade China’s stock of residential housing and office space remains. Indeed, much of what was built only 20 years ago will soon need extensive refurbishment.

The overshoot that resulted from the 2008-10 stimulus is slowly (and unevenly across the country) being unwound.  Year-to-date sales are up 18%, starts are down 21%, and prices are holding steady.  This results in a reduction of GDP growth of up to 1.5% (source: UBS) in 2015. By 2016, property will be contributing to economic growth again.

There will also be a flight to quality in property. One of the legacies of the recent explosion in Tianjin is that consumers will not buy property that is anywhere close to what they perceive might be a risky location.  This event has also driven a flight toward quality developers  who have a reputation for constructing buildings that don’t degrade badly within the first 20 years of their life.

China retains the potential to generate 20-30% of the world’s economic growth for many years to come.  Realizing this potential requires accelerating an already rapid shift to a strong service economy.  But that will only happen if tens, if not hundreds of millions, of people are retrained to succeed in 21st century service businesses, and if service industries become more widely available, are of better quality, and are delivered at lower cost.  This is at the heart of the current economic challenge for China’s government.

Abrazos,

PD1: Interesante con quién se reunió el Presidente chino Xi en su visita a EEUU:

Which U.S.-China Tech Leaders Met with Xi Jinping (And Why)

Chinese President Xi Jinping met Wednesday in Seattle with top executives of U.S. and Chinese tech companies. Here’s a look at the 28 executives — two of them women — who joined the gathering, which comes at a time of mounting tension over cyberattacks and restrictions on U.S. firms.

Pincha este enlace si quieres saber con quién se reunió: http://blogs.wsj.com/chinarealtime/2015/09/24/which-u-s-china-tech-leaders-met-with-xi-jinping-and-why/ La creme de la creme…

Es su tónica habitual, viajar por todo el mundo para verse con todo quisqui, que quiere hacer negocios ahí. Actividad comercial a tope…

PD2: Es Dios quien nos elige. Da la fe a todos, pero al final elige a los que quiere para que vayamos por ahí hablando de Él. Y nosotros lo hacemos porque nos da la gana. El sí a Dios es porque queremos, nadie nos obliga, nadie nos dice lo que tenemos que hacer, es el sí más voluntario del mundo. Un “SI QUIERO” a todo lo que nos vaya pidiendo después…

¿subirán los tipos?

Puede que haya que esperar al 2016, y que, a pesar de lo que dice Yellen, la de la FED, no puedan iniciar la senda alcista hasta más tarde…

Subidas de tipos fallidas

El Banco de Inglaterra (BoE) y la Reserva Federal estadounidense (Fed) son los dos bancos centrales de las principales economías desarrolladas que teóricamente se encuentran más cerca de subir los tipos de interés. Aun así, las subidas podrán esperar, sin descartarse incluso nuevas dosis de compras de activos. En caso de que se produzca el aumento de tipos, puede revertirse en poco tiempo.

En junio de 2014 el gobernador del BoE, Mr Carney, declaraba que "la subida de tipos de interés se iba a producir bastante antes de lo que el mercado esperaba". Quince meses después de dichas declaraciones el alza de tipos ni se ha producido, ni se la espera. Es más, son numerosas las voces que comienzan a reclamar más medidas extraordinarias por parte del Banco de Inglaterra para no acabar con el crecimiento de la economía británica.

La justificación del aplazamiento de la subida de tipos por parte de la Fed centrada en las posibles consecuencias de las turbulencias en China y por extensión en los emergentes introduce una incógnita sobre si realmente se producirá dicha subida. Difícilmente el panorama de China y de los emergentes habrá mejorado significativamente en los próximos meses. Aun así, Yellen sigue anunciando la subida de tipos este mismo año.

Vista la experiencia reciente, es entendible la prudencia de los bancos centrales a la hora de subir tipos de interés. Las autoridades monetarias de todos los países desarrollados redujeron sus tipos de interés hasta niveles mínimos históricos paracombatir la recesión global de 2009. Con posterioridad, hasta ocho bancos centrales de países desarrollados subieron los tipos de interés al considerar que el peligro inflacionista era superior al peligro de hacer descarrilar el crecimiento económico con el endurecimiento de la política monetaria. Todos ellos, sin excepción, han acabado bajando los tipos de interés de nuevo, en la mayoría de los casos incluso por dejado de los niveles previos al inicio de las subidas.

Países muy dependientes de las materias primas como Australia, Canadá o Noruega han tenido que revertir hasta cinco subidas de tipos previas. Corea que comenzó a subir tipos en 2010 ya ha bajado los tipos a niveles inferiores a los existentes en 2009.

Para los más olvidadizos conviene recordar que incluso el BCE, bajo la presidencia deTrichet, erró al subir los tipos en 2011 ante la fantasmagórica "amenaza inflacionista". Afortunadamente su mandato acabó pronto y Draghi retomó la senda bajista de los tipos de interés hasta los nulos niveles actuales.

A pesar de que el Banco de Pagos Internacionales (BIS) lleva años advirtiendo que los bancos centrales con su política monetaria no pueden generar por sí solos crecimiento, sino sólo "comprar tiempo" para que los gobiernos hagan las reformas estructurales necesarias que permitan un mayor crecimiento de la economía, parece evidente que las autoridades monetarias seguirán aplicando nuevas dosis de tipos bajos e inyección de dinero mediante la compra de activos. Draghi lo ha dejado claro. La Fed no tardará en hacerlo.

En esta coyuntura a nadie debería sorprender que los tipos negativos que ahora aplican el BCE o el Banco de Suiza a los depósitos que realizan las entidades financieras en el banco central se acaben generalizando, con un nocivo efecto sobre los ahorradores. Los bancos centrales han creado una economía dopada a la que es muy difícil desenganchar de la adictiva liquidez y tipos mínimos. De momento se prefiere seguir aplicando dosis adicionales de dopaje. Los tipos seguirán muy bajos por más tiempo del esperado, con su efecto inevitable en la valoración del resto de activos.

Si la Fed subiera los tipos este año, como anuncia su presidenta, es muy posible que no tarde en revertir la decisión

Abrazos,

PD1: Las expectativas de rentabilidad para los próximos 7 años, largo plazo me lo fías, no son muy buenas. Ha subido todo tanto que nos esperan una etapa de poco rendimiento:

Se ha ganado demasiado gracias a los estímulos financieros que fluían al mercado:

Pero las fases bajistas en el pasado han sido muy cortas en tiempo, y en profundidad de caída, si se tiene en cuenta la subida previa… Este año puede que sea malo, como lo estamos sufriendo, pero dura poco y nunca se sabe cuando se produce el rebote bueno…, y luego todo vuela.

Además, puedes comprobar que aunque suban los tipos, no afecta a la bolsa. No hay una gran correlación entre la bolsa y los movimientos de la FED… (los tipos de la FED es la raya amarilla, y la bolsa las montañas verdes y rojas)

PD2: Las madres curran como ninguno. Tienen una labor esencial en la crianza de los niños y en la paz de la familia… Estas son unas cuantas mentiras que sueltan para formar a su prole…

no estamos en un mercado bajista

Muchas son las dudas de si se acabó la subida de los mercados, de si entramos en una fase bajista. Yo creo que no, que todavía quedan años de subidas… Se ha vendido mucho estas semanas pasadas, pero a su vez, se ha comprado por el mismo importe, y estos no han sido particulares, sino las manos fuertes… Le meterán otra subida en los próximos meses para sacar provecho a estas compras…

Why this is not the start of a bear market

I have received a fair amount of feedback, mostly from technicians and chartists, on my view that the idea that downside risk on stock prices is limited and this is not the beginning of a major bear market. I want to clarify my views on that topic.

I base my market analysis on different dimensions of analysis, which are summarized as follows:

+ Technical analysis: The stock market has suffered much technical damage, which can be resolved with another leg down, or a sideways consolidation. Trend following models, as well as other projections, suggest considerable downside risk. Call the technical outlook neutral to bearish, with a tilt towards the bearish view.

+ Sentiment analysis: Many sentiment models are showing off-the-charts levels of fear. It isn't any single measure of sentiment, but most sentiment measures an across the board basis. If there is so much fear, who is left to sell? Sentiment models are therefore very bullish.

+ Macro analysis: Here, the outlook is mixed. The US economy is growing so well that the Fed is contemplating raising interest rates. There is no sign of a recession on the horizon, which is a bull market killer. However, there are concerns that the slowdown in China is leaking into other EM economies, which would pull down global growth. As we are mainly focused on the effects on US equities and the US economy remains robust, I would call this neutral to a mild positive.

+ Fundamental momentum: One of the key driver of US equity valuation is earnings growth. Despite much angst over Q3 earnings, forward EPS are still rising, which is still supportive of stock prices. Looking into 2016, however, I do have some concerns about the pace of EPS growth, which could put a ceiling on stock prices. Call this a short-term positive, but medium term neutral to negative.

In short, the most bearish dimension is the technical picture. The other dimensions are either wildly bullish or mildly bullish. But let me go through each component of my analysis, one by one.

The charts look terrible

The long-term technical picture can be summarized by this chart. The SPX saw a violation of the uptrend that began in 2009. Moreover, it has fallen through its 50 and 200 day moving averages. Stock prices generally don`t see V-shaped recoveries when the major averages has suffered this much technical damage.

There are two scenarios to consider. The more optimistic one involves the market finds support somewhere and start to base through a period of sideways consolidation. The more bearish and seemingly consensus scenario among most chartists, is we are likely to see another downleg. The logical downside target would be a key support zone and Fibonacci retracement target at about 1570.

I see a lot of analysis indicating further downside risk. Here are just a few examples. Andrew Thrasher recently highlighted breadth deterioration indicating a bearish outlook.

Kirk Spano (via Marketwatch) pointed to heightened market risk (middle panel) and extreme downside risk (bottom panel):

Even Josh Brown is giving a nod to technical analysis during the current period of market turmoil:
So what can you go by to figure out the mood and psychology around a stock or a market? There’s only one thing: Price itself. And the numerous derivations of price – momentum, relative strength, volume, advancing vs declining issues, moving averages, historical levels of significance.

What you are seeing in price is market psychology writ large. The emotions and attitudes surrounding a given investment are being splattered before you on a canvas. All of the fundamental data that you and others could possibly be aware of is being reflected in the lines on the chart, all day every day.

When you look at these items, they don’t scream out a binary yes-or-no, buy-or-sell answer at you. But they tell you everything you need to know about how people feel. They give you clues to arrive at where the P in PE is headed. Some clues are more valid than others at different times and all clues can fool you. Something that was significant on Tuesday can be an utter red herring on Thursday.

These are just a few of the examples that came across my desk. I could go on, but you get the idea. Technically, the risk-reward of owning stocks right now is very unfavorable.

Sentiment is contrarian bullish

I have demonstrated before (see A test for the bears) that sentiment models are showing a crowded short among several different groups of investors, namely retail (Rydex), US RIAs (NAAIM) and global institutions (BoAML Fund Manager Survey). With respect to sentiment models, I prefer metrics that reflect what people are actually doing with their money, instead of opinion surveys. That's why I give extra weight to measures like Rydex cash flows.

This chart (via Bloomberg) shows that option skew, or the cost of put option downside insurance compared to call option pricing, is elevated (top panel). In addition, short interest has been rising steadily (bottom panel). These are all signs of a contrarian bullish environment.

On the other hand, Barron's shows that "smart money" corporate insiders have been buying heavily since mid-August:

To be sure, sentiment models don't work all the time and they are weak at pinpointing the exact date of a market bottom. I received a thoughtful email from an experienced trader, who highlighted this chart from Ed Yardeni. The green bars show periods when the II bull/bear ratio was under 1.0 (crowded short). To paraphrase Keynes, sentiment can get excessively fearful than the pain threshold of your portfolio.

No indicator works all the time. That's why I rely different dimensions of market analysis.

A benign macro outlook

There are three ways that a bear market can begin:

+ Recession: There is no sign of a US recession on the horizon.

+ Overly aggressive Fed tightening: You've got to be kidding me! Contrast the current Fed with 1987, when the Fed tightened twice in September to defend the Dollar.

+ War or revolution leading a permanent loss of capital: How are those Confederate bonds doing, or those Tsarist Russia railway bonds?

The last two causes are not an issue right now. So let me focus on the risks of a recession.Scott Grannis sees no signs of a recession from the credit markets. Here is his take:

Today, money is abundant and resources are abundant. Even energy is abundant, because its price has fallen by over 50% in the past year or so. Corporate profits are near record highs, the supply of labor is virtually unconstrained, energy is suddenly cheap, and productive capacity is relatively abundant. This adds up to a lot of room for maneuver and very little reason for the economic engine of growth to shut down.

New Deal democrat came to a similar, but more nuanced conclusion. He maintains a weekly watch on the high frequency economic indicators and he divides them into long leading, short leading and coincidental indicators. Here are his latest comments from last week:

This week like last week highlighted the difference between those portions of the US economy most exposed to global forces, which have all turned negative, and those most insulated from global problems, which are all positive, and even strengthening. I suspect that the globe, as a whole, is in recession. With good numbers in housing and vehicle sales, and especially with gas prices declining again, the US is still positive, and although I believe we are past the midpoint of this expansion, I still remain positive through the first half of next year.

The American economy and consumer remains strong. Here is the relative returns of the Consumer Discretionary sector and some of its components relative to the SPX. With the exception of Media, which is underperforming, does this look like the market is worried about the consumer?

The main source of market angst is the slowdown coming from China and its effects on global growth. There are signs that those concerns may be overstated (via Bloomberg):

China’s economy isn’t as weak as it may look, according to a private survey from a New York-based research group that says it’s a myth the nation’s slowdown is intensifying.

“No collapse is nigh” in the aftermath of the stock market plunge and currency devaluation, according to the third-quarter China Beige Book, published by CBB International and modeled on the survey compiled by the Federal Reserve on the U.S. economy. Capital expenditure rebounded slightly in the period and the services sector showed strength, the report said.

“Perceptions of China may be more thoroughly divorced from facts on the ground than at any time in our nearly five years of surveying the economy,” CBB President Leland Miller wrote in the report. “Global sentiment on China has veered sharply bearish--too bearish. While we have long cautioned clients against relying on rosy official views of the Chinese economy, we believe sentiment has swung substantially too far in the opposite direction.”

The report describes a mixed, rather than disastrous, picture of the world’s second-largest economy. Weakening exports, deepening factory-gate deflation and a manufacturing slowdown have highlighted the risk of this year’s expansion undershooting Premier Li Keqiang’s target for growth of about 7 percent.

There are signs that all of the stimulus is paying off as the Chinese economy is starting to see a cyclical upturn. The South China Morning Post reported that the property market and land sales in first and second tier Chinese cities are perking up.

Developers have begun to beef up their land banks as China's residential property market shows signs of steady recovery.

Most of these land purchases are occurring in first- and second-tier cites but the resultant rise in land prices could squeeze some smaller players out of the market, say analysts.

"Land transactions, especially in the first-tier cities, have become very active," said David Ji, head of research and consultancy, Greater China, at international property consultant Knight Frank. "As property prices and transaction volumes rebound, developers have started bidding aggressively to replenish their land banks," he said.

If the US economy remains robust and China is turning up again, what are you so worried about?

EPS expectations holding up (for now)

The fourth major component that I use to analyze the stock market outlook is how EPS expectations are behaving (see my previous post The right and wrong way to analyze earnings for my analytical framework). Right now, forward 12 month EPS are still growing (via Factset, annotations in red are mine).

Ed Yardeni found that forward EPS is highly correlated with coincidental economic indicator and went on to guesstimate that the next recession would start in 2019

SP 500 forward earnings is highly correlated with the US index of coincident economic indicators (CEI). The latter rose to another new record high during August. Previously, I have observed that based on the past five cycles in the CEI, the next recession should start during March 2019. That’s not based on science, but rather on a simple average of the length of the previous expansions once the CEI had rebounded back to its previous cyclical peak. So it’s a benchmark of what could happen based on what happened in the past on average.

In any event, I’ve circled March 2019 as the possible date for the next recession. Given the Fed’s latest decision to do nothing, it’s safe to bet that the next recession won’t be caused by the tightening of monetary policy anytime soon. It could be caused by a severe downturn abroad, I suppose. More likely is that the US will continue to grow fast enough to keep the global economy growing as well, albeit at a pace that is best described as “secular stagnation.”

2015 = 1998 and 2011 (with a difference)

When I put it all together, my conclusion is that the template for the current corrective episode are 1998 and 2011. In both those cases, the US markets were spooked by the fear of contagion from abroad (Russia and Asia in 1998 and Europe in 2011), but the US was largely insulated from negative economic effects and life went on.

Using those episodes as rough roadmaps, the US equity market is likely to stay choppy for the next few weeks until the source of the market angst resolve themselves. It does mean that SPX downside projections of 1570 or lower are overblown. It does not mean, however, that the market will not decline and test the August lows or even the October 2014 lows at about 1820. In all likelihood, I believe we will see another minor leg down to test support in the 1820-1870 zone.

There is a key difference between 2015 and 1988 and 2011. Both of those previous corrective episodes saw the resumption of a bull trend in stock prices. This time, I have my concerns.

Given the excess fear in the markets, stocks are likely to see a reflex rally and a 2100 year-end SPX target is not unreasonable, but I have my doubts as to how much further it can go for fundamental reasons.

There is no question that the Federal Reserve is poised to raise interest rates, the only question is when, not if. When rates rise, it will start to compress the P/E ratio (because the inverse E/P is dependent on interest rates). That will put tremendous pressure on the E in that ratio to expand, which may be doubtful.

The economic cycle is maturing and the signs of a tightening labor market are everywhere. The key question as we look forward into 2016. How much can earnings grow in the face of margin pressure from rising labor costs? Jim Paulsen of Wells Capital Management recently voiced these worries, though he phrased his concerns in the context of an aging profit cycle (emphasis added):

Earnings performance is well past its best for this recovery and investors need to consider whether earnings growth will prove sufficient to support current stock market valuations. The rapidly aging earnings cycle is perhaps best illustrated by an economy nearing full employment with corporate profit margins near record highs.Should global growth remain tepid and overall sales results modest, since profit margins are unlikely to rise much, earnings trends will also likely prove disappointing. Conversely, should global growth and corporate sales results accelerate, because the U.S. is nearing full employment, companies may soon face cost-push pressures and margin erosion which will likely off set improved sales results.

Essentially, it is difficult to see how earnings growth will be adequate during the rest of this mature recovery to support current price/earnings multiples. Is a relatively modest earnings growth against a backdrop of rising inflation and higher interest rates sufficient to support the current 18 to 19 times price/earnings multiple?

Indeed, the latest speech from Janet Yellen today indicated that the economy is nearing full employment (emphasis added):

Although other indicators suggest that the unemployment rate currently understates how much slack remains in the labor market, on balance the economy is no longer far away from full employment.

In that case, wage pressures will surely start to pressure operating margins.

Margins could unexpectedly improve should the USD weaken. Factset did show that there is a distinct difference in Q3 earnings and revenue growth for companies exposed to the domestic economy compared to foreign sourced sales (annotations in red are mine).

In conclusion, my base case scenario calls for the market to bounce around for the next few weeks, with a rally into year-end and January. Looking out into 2016, labor costs and the USD will be key drivers of SPX profit expectations - and stock prices. In the absence of a retreat in the USD, the SPX will likely become range-bound in 2016 with 2100-2200 as a ceiling and 1900-2000 as a floor, which would fit well with a resolution of the technical damage done through a period of basing and sideways consolidation.

One last word addressed to my bearish doubters. Before you start flaming me, just a reminder that this post is in effect a mirror image of what I wrote in May: Why I am bearish (and what would change my mind).

Abrazos,

PD1: En España, las cosas pintan bastos para la bolsa. La evolución del mercado de valores español en los últimos 5 años ha sido terrorífico. Muchos valores se han vuelto a los mínimos que alcanzaron en la crisis de 2008 y sus pérdidas son descomunales desde el principio del año 2000, tras haber pasado ya más de 15 años…

BANCO SANTANDER: Ha perdido mucho desde el año 2000: la burrada del 58.64%...

Incluso, si no nos vamos tan lejos y cogemos su evolución en los últimos 5 años, el desplome es formidable, de casi un 50%... Qué sí, que es el Santander, el que anda captando clientes como un loco con su nueva cuenta, pero que tiene unas grandes inversiones en Brasil y tal…

BBVA: Lo mismo le ocurre, con un palme del 44,17%

POPULAR: Los bancos pequeños, en su conjunto, son otra historia más grave, desplome total:

TELEFONICA: Lo mismo. Pierde un 52,98% en 15 años…

Y en los últimos 5 años no consigue levantar cabeza…

REPSOL: En mínimos de los últimos 15 años, tras perder un 53,58%

Con una espectacular galleta del en los últimos 5, por culpa del descenso del precio del petróleo:

FCC: En las otras constructoras hay de todo…

OHL:

SACYR:

En su conjunto, la bolsa española presenta un panorama desolador en los últimos 5 años y desde el año 2000… ¿No está descontando la realidad económica creciente, boyante, que hay en España? ¿No crecemos al 3% el PIB y estamos que nos salimos…? Parece que el mercado de valores no se acaba de enterar y tal, o es que está descontando un populismo creciente que les pone catatónicos a los inversores en los valores españoles; andan acojonaditos vivos… ¿Mejoraremos en los próximos 5 años? ¿Y en los próximos 15? Recuerdas que te he recomendado estar fuera sistemáticamente de la bolsa española, era por algo… Siempre que inviertas tienes que pensar si es interesante a largo plazo, a 10 años vista. Si tienes dudas, es mejor no invertir, ya que a corto plazo hay más riesgos…

Hace unos pocos meses salió a cotizar TALGO. Me preguntaron los clientes con insistencia si compraban o no. Les recomendé que no. Ahora se les cae el contrato en el Medio Oriente y la bajada en bolsa ha sido espectacular: Ha palmado casi un 50% desde su colocación en bolsa hace 5 meses…

PD2: "Mientras más vacío está el corazón de la persona, más necesita objetos para comprar, poseer y consumir", frase de la LaudatoSi, del Papa Francisco.