SPY: Why S&P 500 3,500 Makes Sense Here

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Why S&P 500 3,500 Makes Sense

As the S&P 500/SPDR S&P 500 ETF (SPY) trades around all-time highs, the next leg of this bull market is about to begin.

Source: StockCharts.com

There are many elements that suggest stocks will continue to climb the proverbial wall of worry from here, but amongst the most prominent factors include:

  • A stronger than anticipated economy in the U.S.
  • A cooperative and supportive Fed
  • An inflationary backdrop that permits rate cuts
  • A likely return of bullish sector rotation
  • Seasonal dynamics
  • A probability for multiple expansion in key sectors
  • Progress on trade issues with China
  • A possibility for a second term/Trump re-election in 2020

These fundamental elements, along with other technical and psychological phenomena, should enable the current bull market to continue for at least another several quarters, possibly even years.

I expect the S&P 500 can have a stronger-than-expected second half in 2019, and stocks could end the year close to 3,500, roughly $350 in SPY terms.

About SPY

SPY is the first major and most popular ETF in the world. It’s designed to mimic the exact movement of the S&P 500. The SPY index fund has roughly $270 billion in net assets, and each share in the fund represents a fraction of the holdings.

SPY provides investors with exposure to the S&P 500 index, which is widely regarded as the most significant stock market average for U.S. equities.

Data by YCharts

Since SPY essentially tracks the exact movements of the S&P 500, I will use SPY and the S&P 500/SPX interchangeably throughout this article.

We can see that SPY’s and the S&P 500’s performances have been essentially identical over the last 5 years. The same applies to other time intervals as well.

Economy Stronger Than Anticipated

Let’s begin by examining some of the recent economic indicators hitting the wire. Just looking back at the last few weeks we see a lot of strong or better-than-expected economic readings.

For example:

ISM manufacturing PMI for June beat estimates by 0.7%. The number came in at 51.7, indicative of an expanding manufacturing base in the U.S. Services PMI also came in better than expected, beating estimates and last month’s figure by 0.8%.

Perhaps the biggest surprise in recent weeks was the much stronger-than-expected nonfarm payrolls report. 224K new jobs were created in the month of June, a 40% beat over estimates that called for just 160K new jobs to be created.

Q1 GDP came in at 3.1%, as expected, but also indicative of a relatively robust economy in the U.S. PCE inflation came in at 1.6%, not too hot and not too cold, in fact just right to permit the Fed to lower its benchmark rate.

The Fed Put is Here to Stay

What makes the current economic environment unique is that despite the economy being in relatively good shape, and the S&P 500/SPY being at all-time highs, the “Fed Put” appears to be firmly back on the table.

In fact, not only is the Fed Put back, the Fed is overwhelmingly likely about to embark on an easing cycle despite stocks being at all-time highs. Right now, the market is pricing in a 100% chance for a July rate cut, with about a 4% probability for a 50-basis point cut vs. just a 25-point cut.

Source: CMEGroup.com

Moreover, if we look out further, rates are likely to be 50–100 basis points lower by May of next year.

This is unprecedented; never has the Fed been so proactive in attempting to delay or “prevent” a recession. The Fed has never cut interest rates with the stock markets at or near all-time highs. This is essentially new and uncharted territory we are entering, and this phenomenon is likely to elevate SPY and stock prices in general higher from here.

Inflation Permits Fed Easing

What is quite interesting is that the Fed’s preferred gauge of inflation, the PCE, is only at 1.6%, well below the Fed’s target rate of 2%. CPI inflation is also below 2% (1.8% latest reading), and even YoY wage growth numbers came in slightly lower than expected, 3.1%, vs. the expected 3.2% last month.

CPI Inflation

Source: TradingEconomics.com

PCE Inflation

Source: Investing.com

All these figures indicate that inflation is not nearly as hot as it was a year ago. To the contrary, inflation is relatively tame, in fact, well below the Fed’s 2% target rate. Therefore, it is appropriate given the Fed’s dual mandate (one being price stability/inflation around 2%), to cut rates going forward.

Sector Rotation Likely to Improve

We’ve seen inflows into defensive sectors lately (utilities, real estate, staples, etc.). In fact, due to the “fear” of a possible recession, these sectors have become overbought as many P/E ratios in defensive companies have gone up significantly over the past year.

On the other hand, P/E ratios in financials, technology, energy, and other more cyclical areas of the market have come down and/or are relatively inexpensive. For instance, the current P/E ratio for the Nasdaq 100 is around 24.5, lower than it was 1-year ago.

Moreover, if we look at forward estimates, the Nasdaq 100 is trading at just 21.75, the SPX is trading at just 17.9, and the Russell 2000 is trading at only 25 times forward EPS estimates. Keep in mind that 1 year ago the Russell 2000 was trading at over 85 times earnings, and the SPX was trading at over 24.

Source: WSJ.com

In relation to SPY and the S&P 500, about 26% of the weight is technology, and 16% are financials. Another major sector is healthcare, accounting for about 14% of the weight. Thus, the three biggest sectors in SPY/S&P 500 account for roughly 56% of total ETF/index weight.

Source: ETF.com

Financials are particularly cheap on a P/E basis right now, trading at around 10. Therefore, we could see sector rotation and multiple expansions here as well as in technology. Many healthcare names are cheap, and I consider this to be amongst the best sectors right now due to many companies having low P/E ratios and the sector’s defensive nature.

I believe we are going to see rotation out of the overbought defensive sectors like utilities, staples, possibly even real estate. Capital will likely flow back into more cyclical sectors like technology, financials, and others. Also, healthcare will likely benefit as many high-quality companies are quite cheap in this segment right now.

For instance, Bristol-Myers Squibb (BMY) is trading at just 10.3 times forward EPS estimates, and provides a dividend of 3.57%. I own other very attractive healthcare names in my portfolio. For more information, please visit here.

An important factor to consider is that segments like utilities are relatively small, relative to their weight in SPY/S&P 500, just 3.5%. Therefore, rotation out of overbought defensive segments like utilities should have a very limited effect on SPY’s overall performance.

At the same time, rotation into the ETF’s largest segments like technology, financials, and healthcare should enable SPY and the S&P 500 to go substantially higher going forward.

‘Tis The Season for Higher Stock Prices in H2

Another factor to consider is seasonality. Summer is typically a slow time for stock markets; many market participants even “sell in May and go away.” Therefore, I expect we can have a strong second half in 2019 as many market participants return towards the end of the summer and we could have a very strong rally into year-end, especially with the Fed cutting rates, China trade issues improving, and the economy remaining relatively strong.

Multiples Could Expand

Like I mentioned before, many multiples are quite depressed given the current atypical economic environment. The DJIA is trading at just 16.5 times forward earnings estimates, the Dow transportation average is at around 14 forward earnings estimates, the SPX is under 18 forward earnings estimates, the Nasdaq 100 is under 22 times forward earnings estimates, and the Russell 2000 is at just 25 times forward earnings estimates.

Now, these may not seem “cheap” relative to historical figures, but at the same time, they are not particularly expensive either. Furthermore, given that the Fed is about to embark on another easing cycle, which could turn out to be a multi-year process, multiples are likely to expand going forward which should lead to higher stock prices in general.

Progress on Trade: A Crucial Element Falls into Place

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Despite all the noise and saber rattling, progress was made at the G20 summit. The fact of the matter is that both countries need trade relations to normalize. China needs strong relations with the U.S. as it produces hundreds of billions worth of products flowing into U.S. markets each year, and the U.S. needs strong trade relations with China to keep inflation under control, and to prevent the U.S. from falling into a recession.

Additionally, President Trump needs a healthy, upward moving stock market to strengthen his re-election chances. Therefore, I am relatively optimistic on this front, following the latest developments.

Trump’s Re-election Chances Appear Strong

Whether you like the President or not is up to you, but the fact is that the stock markets like President Trump and his pro-growth policies. After all, President Trump introduced enormous corporate tax cuts, is bringing manufacturing jobs back to the U.S., is attempting to establish more favorable trade relations with European countries, China and other nations, is heavily pressuring the Fed to lower rates, and is implementing other measures to enable the U.S. economy to grow and prosper.

Source: Washington Times

President Trump is a pro-market, pro-free and fair trade kind of President. This is precisely the kind of leader market participants should want to remain in the White House. The possibility of a regime change to a Democratic president, and god forbid a “socialist” type leader, may not be beneficial for SPY or for stocks in general.

The good news is that there is likely no one amongst the Democratic candidates that will defeat Trump in a general election. After Joe Biden’s recent “slide,” the field of potential opponents is looking weaker and weaker for the Democrats.

I know, it may be too early to make predictions about the outcome of the 2020 election right now, but I believe there is a high probability President Trump will become a two-term president, and that is great news for SPY and stock markets in general, in my view.

Bottom Line: The Next Leg Higher Just Began

The stars are aligning to propel SPY, the S&P 500, and stocks in general higher from here. Stocks are at all-time highs, the economy is relatively strong, the Fed is about to embark on an easing cycle, inflation is in the Goldilocks zone, and we are likely to witness bullish sector rotation.

Moreover, signs of progress relating to the U.S., China trade tensions are becoming more evident, there are bullish seasonal factors to consider, and President Trump has a strong chance of being re-elected in 2020.

Ultimately, animal spirits could come back to this market, multiples are likely to expand, and stocks could go much higher. If the economy does not begin to unravel and show wide-ranging signs of an upcoming recession, the Fed eases rates, and more progress is achieved on the China/U.S. trade front, I expect SPY could end the year at around $350, or roughly 3,500 on the S&P 500.

Remain Cautious Going Forward

While I am bullish short term, a recession is an inescapable part of the economic cycle. There have always been recessions and one could materialize within the next 9-18. However, with enough Fed stimulus it is possible that a recession could be pushed out by several years, not just a few quarters. Nevertheless, I advocate a healthy level of caution going forward, and don’t expect this bull market to run forever, as any detrimental unforeseen elements could derail the economy and cause a significant drop in the stock market.

Disclosure: I am/we are long NUMEROUS STOCKS IN THE S&P 500. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article expresses solely my opinions, is produced for informational purposes only and is not a recommendation to buy or sell any securities. Investing comes with risk to loss of principal. Please consider consulting a professional before putting any capital at risk.