It is no surprise to me that the DJIA has recovered to 10,000 and the S&P 500 Index is approaching 1100. There are several fundamental reasons this recovery has happened and will likely continue. In the near term, I am bullish on the general market. In the longer term, I am especially bullish on strong businesses.
- Earnings are artificially low. Transaction volumes have been extraordinarily off in almost every business in almost every industry, primarily as a result of extreme decreases in confidence brought about by the extraordinary crises of last fall and winter. The underlying economic engine of our economy is still massive. The effects of these one-off crises are atrophying. Transaction volumes will return to normal levels, and revenues will grow at accelerating rates in the near term. Moreover, earnings will continue to grow faster than revenues. Most companies tightened their belts, got scrappy, and will come out of this recession healthier and with better muscle tone. They will enjoy increasing revenues with leaner cost structures, leading to even faster earnings growth in the near term.
- Investment is increasing. Consumers adopted some healthier choices as well. Higher savings rates lead to increased investment, much of which is waiting to be redeployed in business-building, which should lead to growth.
- Stimulus is just starting. I admit that the stimulus spending could have been tremendously more effective than the peanut-butter package spearheaded by a self-interested Congress. Still, most of the massive monetary and fiscal stimulus has not yet taken effect on the economy. Economists understand that these initiatives can take many months to bloom. Once they do, consumption will accelerate further.
However, we should proceed with some caution. There are at least two major threats to the general market.
Threat No. 1: Our government does not seem to be prioritizing economic growth. There seems to be tremendous focus on health care, regulation, spending, and fairness as opposed to, say, the reduction of marginal tax rates. Bigger government and higher marginal income tax rates are not prescriptions for economic growth. Still, my bet is that our economic engine and pressures from the electorate will help us outlast the lack of attention to growth, but this remains to be seen.
Threat No. 2 (Also a Double-Play Opportunity!): The multitrillion-dollar stimulus that has been pumped into our economy is unprecedented. While this will likely create real growth in the near term, it is likely to lead to significant inflation down the road. Weaker companies' earnings will suffer as they will not be able to pass on the full extent of their cost increases.
However, the stocks of companies with strong business models, competitive advantages, and loyal customers should offer very profitable inflation hedges. Iconic companies like Costco
In this way, solid companies provide an effective hedge against the threat of inflation, assuming investors simply continue to value these companies at today's multiples. But wait, there's more: On top of the nominal growth, you still have the real growth upside that comes with well-run, strong companies. Therein lies the double play.
Bullish like me? Bearish? Let me know in the comments section below.
Motley Fool President Scott Schedler does not own shares of any companies mentioned. Google is a Motley Fool Rule Breakers recommendation. Apple, Adobe Systems, and Costco Wholesale are Motley Fool Stock Advisor selections. Costco Wholesale and Paychex are Motley Fool Inside Value picks. Paychex is a Motley Fool Income Investor recommendation. Vail Resorts is a Motley Fool Hidden Gems pick. The Fool owns shares of Vail Resorts and Costco Wholesale. The Fool is investors writing for investors.