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Global Outlook

Case For A Bull Market

June 18, 2014, Wednesday, 06:52 GMT | 02:52 EST | 11:22 IST | 13:52 SGT
Contributed by eResearch


For some time I have been calling for a market correction. This is nothing to fear. Corrections entail sell-offs of 10% or more in the S&P 500 over a couple of months, and are necessary to prevent asset bubbles.

In previous commentaries, I have expressed my concern that the market cap of the publicly-traded companies in the USA relative to GDP is too high given historical levels of the ratio. I am still bothered that the majority of corporate earnings growth has materialized from cost savings due to margin expansion, and that this may not be sustainable without organic corporate revenue growth.

Additionally, the majority of gains in the S&P 500 over the past year materialized from P/E expansion rather than earnings growth, and the P/E multiple of the market can only go so high.

At the same time, I have been indicating that bull markets rarely end at average P/E levels, and the level of speculative fervor you find near the tail end of a bull market simply is not yet present.

There remains a wall-of-worry for the market to climb based on the low growth economic recovery. Additionally, interest rates are incredibly low which is pumping up market valuations, and the European central bank is becoming more accommodative with its monetary policy.


The Bull Case for This Market

None other than Larry Summers, the former Secretary of the Treasury, advanced the Bull Case for the stock market to defy those calling for a correction. He predicts it will continue to head substantially higher. Summers' bull-market case is fascinating.

His thesis is that the economy has structurally changed. This change is basically that capital and labor are no longer complementary.

In the past, to produce goods you needed people, and people needed machines to produce goods. If you were running an automobile factory in the 1950s, you needed assembly line workers plus the machines or capital that were used by the people.

What Larry Summers is proposing is that, starting in the late 1990s, capital began to be not a complement but a substitute for labor. Essentially, the automobile factory no longer needs the same ratio of people to machines. Effectively, the people making the cars can be replaced with technology.


An Accelerating Trend

More and more, technology is serving as a substitute for labor. Think of all the travel agents that were replaced by the Internet. What about the book store clerks whose jobs were destroyed by Amazon, or the newspaper delivery boys being put out of business by iPhones?

The argument goes that, because technology is substituting for labor, an increase in labor productivity will not cause an increase in wages. In the past, greater capital meant higher productivity, which leads to more jobs and higher wages. What Larry Summers is saying is that increased demand for technology is actually lowering demand for labor.


Where Is the Money Going?

This is causing the aggregate share of labor income to decline and the share of capital to rise. From a common sense perspective, if capital is a substitute for labor the economic pie is going to go more and more to those that own the capital and less to those that own the labor. This is the explanation for the growing amount of income inequality in the world. People are being replaced by technology and the capitalists are taking greater and greater gains from economic growth.

The result is that the jobs in most demand are: ( 1) very low-wage jobs, like barbers, that are not easily replaced by technology; or ( 2) very high-wage positions that require extensive analytical abilities that are also hard to replace with machines.

Retail clerks, assembly line workers, travel agents, and even low-level legal workers are all being replaced by technology. Meanwhile, high-level corporate managers who direct complex operations are seeing their wages increase.


Big Advantage for the Stock Market

This disruption is extremely positive for publicly-traded corporations. We would expect to see higher profit margins in aggregate as a result of low wage growth and this is exactly what we are witnessing.

Twenty years ago, the largest publicly-traded companies in the USA employed far more people. Google, Microsoft, and Facebook simply do not need the same number of workers as U.S. Steel and General Motors required. In fact, the size of corporations in terms of employees has been declining over time. Even manufacturing and energy companies are employing fewer people and more and more technology.

If this shift from capital being a complement to labor to becoming a replacement for labor is truly here, the effect will be twofold:

First, and foremost, interest rates will remain much lower for a longer time than anyone is currently anticipating. With capital replacing labor, wages remain under pressure. As I have said many times, there has never been a period of price inflation that has not been accompanied by a period of wage inflation.

Second, and most important to investors, the stock market should go much higher than what people, including me, are anticipating. If technological advances are causing capital to get a greater percentage of the economic pie than it used to, the best course of action is to own the capital. In other words, invest in the stock market.

Then, when you combine the structural shift in the economy with the way globalization is increasing the labor supply, and factor in the decline of labor unions, we are looking at a prolonged period of stagnant wage growth.

Our current outlook for the market might actually be somewhat conservative if the trend of wages not increasing continues to persist.


What Do I Think of This?

Well, an old saw of wisdom is that when people start saying that "This time it is different," they are usually mistaken. The theory that capital and technology are becoming substitutes for labor is a well thought out, if not brilliant, argument. It explains why interest rates are globally low, profit margins are high, wages are stagnant, inflation is benign, inequality is rising and, yet, the market keeps heading higher and the P/E multiple keeps expanding. The theory explains the data, but brilliant theories usually do.

However, I tend to feel that the more things change the more they stay the same, especially with regard to the equity market. This time around nothing is different.

Wages will eventually go up, inflation will return, interest rates will rise, and the market will appreciate not at an accelerated rate but at its historical rate of 6% above the riskfree interest rates.

Summers' argument is very powerful, but it is simply a brilliant way of saying "This time things are different."


So What Should You Do?

A market correction, unfortunately, is not out of the cards. Corrections will materialize and the best course of action, as always, will be to continue to hold equities even when interest rates begin to rise.

If you want the Zacks point of view on what is going to happen with the market moving forward, you are welcome to download our June Market Outlook.

This intelligence has been reserved for our private clients but, today, I am opening it up to you for free. Now you can see our latest, detailed predictions on GDP growth, inflation's next trend, where the market's headed through 2014 and 2015, and more.

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