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The case for a stock rally into year's end

Despite signs of a stalling U.S. economy and the approach of a potentially very disappointing third-quarter earnings season, Wall Street has been ripping higher -- and that's likely the direction it'll keep going for the next couple of months. Ignoring those troubling indicators, investors are instead responding to growing odds the Federal Reserve will hold off on raising interest rates this year. Futures market pricing now puts better-than-even odds of rate liftoff in March 2016.

It's clear that the monetary policymakers are growing increasingly concerned about still-soft inflation and global economic worries.

As stocks react positively, it proves -- once again -- that in this bull market, the flow of monetary stimulus overrides traditional fundamentals like corporate profitability and GDP growth. And thus, the stage is set for rip-roaring rally through the end of the year as the Dow Jones industrials index retakes the 17,000 level.


Consider that according to Macroeconomic Advisors, U.S. GDP growth is tracking at just a 1.3 percent annualized rate as factors like lower inventories and a widening trade deficit stifle growth. Or consider that, according to Factset, third-quarter earnings for the S&P 500 are expected to decline 5.5 jpercent in what could be the first back-to-back drop in earnings since 2009.

Already, 76 S&P 500 companies have issued negative earnings per share guidance vs. 32 issuing positive guidance. Alcoa (AA), which unofficially kicked things off on Thursday, wet the bed: Shares dropped 6.8 percent on Friday after Alcoa's operating earnings and earnings per share both missed expectations. Analysts highlighted pricing and foreign exchange headwinds as well as soft profit margins in its Engineered Products category.

Globally, Capital Economics estimates that worldwide GDP growth will slow to around 2.5 percent this year. This, along with the recent strength in the U.S. dollar fueled by a looming Fed rate hike, has pushed down energy and commodity prices all year, weighing on corporate earnings.


By inching away from the rate hike launch button, the Fed has started to reverse this self-sustaining negative feedback loop. Suddenly, there's hope. And investors are scouring the tape for bargains in beaten-down sectors like oil and gas and among forgotten names like Caterpillar (CAT) -- forlorn since inflation expectations started falling in the summer of 2014. Crude oil tested above the $50-a-barrel level for the first time in months, as the chart above shows.

Chicago Fed President Charles Evans said on Friday he expects the Fed policy rate to be below 1 percent in late 2016 and inflation to be below 2 percent by the end of 2018. He added that forces holding down inflation were unlikely to subside before the middle of 2016, adding further evidence to the early- to mid-2016 window for a rate liftoff.

Also on Friday, Fed Vice Chairman Stanley Fischer added that the central bank is paying increasing attention to international events (read: the situation in China), and while the Fed's mandate is based on U.S. economic performance, the Fed doesn't want to damage the global economy.

Unless Chairman Janet Yellen breaks the Fed's traditional pattern, stocks are sniffing out a reacceleration of growth and earnings in 2016 on expectations that the zero-interest rate policy will enter its ninth calendar year. After all, in the Fed's last two tightening cycles, rate hikes didn't happen unless the futures market was well prepared. The U.S. central bank isn't in the business of delivering negative surprises to Wall Street.

Michael Pearce at Capital Economics is looking for global GDP to stabilize next year as China bounces back and Brazil and Russia (both of which are China-dependent commodity exporters) regain some footing. Already, based on things like real estate activity, China is showing some sparks of vitality again. Global GDP, in Pearce's estimation, should clock in around 3 percent in 2016.

As for earnings, the team at Bank of America Merrill Lynch led by Savita Subramanian believe actual results won't be as bad as analysts currently believe, thanks to a relatively flat U.S. dollar during the third quarter (which will help the value of their foreign earnings).

With 20 percent of S&P 500 stocks set to report earnings this week, Subramanian's team is looking for overall results to come in roughly unchanged over the year-ago period.

If so, the S&P 500's upward cross of its 50-day moving average last week -- a measure of medium-term trend -- would be just the start of a multi-month rally. According to SentimenTrader, this hasn't happened since August and when following a correction, has historically presaged at least a month of rising stock prices.

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