JPMorgan chief U.S. equity strategist Tom Lee says the end of the government shutdown is bullish for stocks.
The S&P 500 has already rallied 4% in the last week as hopes increased that warring parties in Washington, D.C. were close to a deal to end the shutdown and raise the debt ceiling.
Now, the index is only 3% away from Lee's year-end target of 1775 — the most optimistic forecast on Wall Street.
In a note to clients, Lee puts forward " 4 reasons post-shutdown relief argues for at least 1775" on the S&P 500:
Foremost, fundamentals remain solid and 3Q earnings season is expected to underscore this. As we noted in our 3Q13 preview (see "3Q13E Preview: $28.00 EPS, on track for $110 FY13 EPS" dated 10/15), this is likely to be the best reporting season in 2013: (i) top-line growth of 3% is estimated to be the highest in 2013; (ii) the profit contribution from Cyclicals has turned positive, adding $0.46 of the $1.01 y/y increase in EPS (Cyclicals were negative in 1H13) and (iii) a beat ratio of 69% is the best so far in 2013. The underlying driver, in our opinion, is pent-up demand in the US (housing and autos) and a manufacturing lift in Europe.
Second, history shows that markets tend to rally post-government shutdown: 4 of 5 precedent instances of shutdowns (>10 days) saw rallies into YE. As shown on Figure 1, equity markets rallied in 4 of the 5 instances (‘76, ‘77, ‘79 and ‘96) mostly by 3%-6%, with the Fall of ‘78 as the sole exception (we had the fomenting of the Iranian Revolution in ‘78, which could explain the lack of a rally). Moreover, in Fall ‘11, post the conclusion of the Supercommittee, equities gained 10% over the following 3 months (see Figure 2). Bottom line, our 1775 YE target is a mere 3% gain from here, which falls within the range of prior post-shutdown relief rallies.
Third, investor positioning, particularly mutual funds, suggests that clients are likely to add risk into YE. As shown on Figure 4, mutual fund beta has been steadily declining since 9/2 and is actually lower than it was right after the conclusion of the Supercommittee (Nov ‘11) just as equity markets were troughing. Hedge fund beta has actually lifted in the last few days, suggesting much of the rally since last Tuesday was driven by HF position squaring.
Fourth, the Fed is likely to be on hold even longer given the potential for a political redux in early 2014 and also the near-term “corruption” of economic data. Lastly, we expect the Fed to remain accommodative and that tightening concerns will likely be pushed later into 2013. There is also additional concerns surrounding the potential for another debt ceiling showdown in early 2014 and as a consequence, we would expect the Fed to exercise similar forbearance as we enter the new year. Moreover, in the near-term, we believe incoming economic data will be viewed as relatively unreliable given the government disruption and the lack of integrity surrounding near-term results.
"We have likely avoided a default, a binary outcome that posed great risk to our thesis (even if the likelihood of a negative outcome was small, in our view)," says Lee. "Hence, we are personally relieved as well."
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