While Ms. Market's game can change at the drop of a hat/tweet, it appears stocks have spent the last couple of weeks digesting the latest onslaught of news from the likes of Moody's, the White House, and the courts. The good news is the major indices have not succumbed to bears' latest efforts nor headlines that might have created heavy selling a couple months back.

Looking On The Bright Side

From my seat, stocks are looking on the economic bright side these days and have been basically "hanging around" for the better part of the last three weeks. As in hanging around the old highs, the high point for this cycle, and the seemingly all-important 200-day moving average.

The fact that the S&P 500 recovered the vast majority of the "tariff tantrum" decline (in record time, I might add) and has yet to show any signs of a meaningful retest, should be viewed as a positive.

Granted, the market has not moved on to new highs and the tariff threats continue to pour in almost daily. As such, our furry friends in the bear camp argue that it's only a matter of time before traders begin to rethink their current optimistic view.

After all, there are still two fairly large gaps on the chart of the S&P - the first of which resides down to 5961 and the second sits at 5309. And market technicians remind us that both of these gaps ought to be filled at some point in the near future.

All About Earnings, But...

While I am a card-carrying member of The Glass is at Least Half Full club and I am pleased to see stocks positioned optimistically at the moment, my take is that investors may want to curb their enthusiasm about the potential upside from here. Well, at least for a while, anyway.

At the end of last year, my theory was that stocks had gotten ahead of themselves. I opined that traders had "pulled forward" gains attributable to the strong earnings that were expected to come. As we've discussed, at that time consensus EPS estimates for S&P 500 earnings growth stood at +16%. As such, it made sense for stocks to be at all-time highs.

The problem was that those expected earnings were still a long ways off. And with P/E multiples starting the year at historically high levels, I felt that the market was at risk if the strong earnings didn't show up.

Then the tariff tantrum began. And sure enough, with analysts hacking away at their earnings estimates, some adjustment to the downside occurred in the stock market indices. But, as Wall Street is famous for doing, the "adjustment" quickly became overdone.

Next came the realization that the White House was indeed using tariff threats as negotiating tools and had no intention of burning down the house in the process of improving trade deals. This resulted in investors of all shapes and sizes scooping up their favorite names with some eye-popping returns happening since early April.

Which Way From Here?

So... With the major indices back to within spitting distance of their all-time highs, the question becomes, where do we go from here?

When faced with questions like this, I usually turn to Ned Davis Research's Cycle Composite, which is a mashup of all the one-year, four-year, and ten-year decennial cycles since 1900. As I've pointed out a time or twenty over the years, the trend projections of this work is usually pretty good. Oftentimes scary good.

Checking in on the Cycle Composite, it looks like stocks are projected to move steadily higher into the middle of July. From there, the bulls look to be ready to take a break into late fall before the traditional year-end rally begins. Works for me.

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Copyright Ned Davis Research Group, All Rights Reserved

Then if one looks at the consensus earnings projections over the next year and a half, you have to feel pretty good about the upside potential. Again, with EPS growth expected to be nearly +10% this year (which, of course, is down from +16% at the beginning of the year) and more than +14.5% next year, it isn't a stretch to think that stocks should follow suit to higher ground.

Valuations Are Still a Problem

If one had been off trekking across the mountains for the first five months of the year and is just now checking in on where the markets are, they couldn't be blamed for thinking not much has really changed since New Years Day.

The economy is rolling along. Inflation is trending lower but appears a bit sticky here. Rates are about where they were to start the year. The Fed is off the war path. And earnings continue to come in at all-time highs. What's not to like, right?

The problem is valuations remain in nosebleed territory. And with so much uncertainty hanging over this market, it is tough to see how investors are going to pay even higher multiples than they are now.

The chart below illustrates the Forward P/E Ratio (calculated by taking the current price of the S&P and dividing it by the consensus earnings for the next 12 months) of the S&P 500 and really tells the story...

S&P 500 Forward P/E Ratio

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* Source: Ned Davis Research

With the current Forward P/E currently sitting north of 21, it is hard to argue that stocks aren't expensive from an historical perspective. In fact, the market has only traded higher than current levels a couple times over the past 40+ years.

This, in and of itself, does not mean that stocks must go down. No, assuming earnings continue to grow at a healthy clip, then P/E ratios can remain high for some time. Assuming investors think the future still looks bright.

The issue is that with valuations are already high based on earnings more than a year out, we probably shouldn't expect to see much in the way of multiple expansion in the coming months. Especially if uncertainty rises over the state of the economy and inflation.

Time To Be Defensive?

To be clear, I am NOT suggesting that folks should run out and sell stocks. No, as long as the earnings and economic expectations remain upbeat, then I am very happy to hold positions - especially those in the growthiest areas.

The bottom line is that we could be in for a bit of a slog for a while – until the earnings can catch up to current pricing.

But if Mr. Dimon's much ballyhooed storm clouds begin to form, we may need to reach for those risk mitigation strategies again. So, it is probably a good idea to be prepared - you know, just in case.

Thought for the Day:

The man who has no imagination has no wings. -Muhammad Ali

Wishing you green screens and all the best for a great day,

David D. Moenning
Founder, Chief Investment Officer
Heritage Capital Research, a Registered Investment Advisor

Disclosures

At the time of publication, Mr. Moenning held long positions in the following securities mentioned: None - Note that positions may change at any time.

NOT INDIVIDUAL INVESTMENT ADVICE. IMPORTANT FURTHER DISCLOSURES