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This Rally Still Has Plenty of Room to Run

The world's awash in cash; that means more upside for stocks.

Nervous? With the stock market hitting new all-time highs just about every day, I certainly hope you're feeling cautious.

As we celebrate the lunar new year and move into the Year of the Pig, it's certainly a good time to remember the old Wall Street saw about hogs getting slaughtered. Now is not the time to forget about fundamentals or to ignore price targets.

But it's not time to bail out, either. Some pretty strong currents are still running in this market's favor, and we're likely to climb the famous Wall Street wall of worry to even higher highs over the next few months.

Up, Up and Away

That said, this certainly isn't the time to be laying on risk with a trowel. (See preceding wall metaphor.) And it certainly is becoming harder and harder to find a bargain in the stock market.

On Feb. 16, the

Dow Jones Industrial Average

closed at 12,767, a record for the closing price on the index. That close erased the record of 12,765, set just the day before. The close was the 29th new high since Oct. 3, when the Dow broke a six-year-old record.

The rally has been remarkable for its longevity, its lack of corrections and its breadth. It's now four-and-a-half years old, making it the third-longest bull market on record. Much of that climb has been without significant backsliding: For the past 47 months, the market has climbed without a 10% correction, says Jim Stack of InvesTech Research.

Most sectors of the stock market have participated in this rally; only 19 times since 1929 have the Dow industrial, utility and transportation averages hit simultaneous record highs, as they did Feb. 14.

Not All the News Is Good

All that good news is enough to make any investor nervous. If you want to worry, you can -- if you must -- find things to worry about:

  • Earnings growth, which has been above 10% for most of this rally, is slowing. It looks like earnings growth on the stocks in the Standard & Poor's 500 Index will come in just below 10% for the December 2006 quarter, and Wall Street analysts are projecting just 5% growth for the first quarter of 2007.
  • Economic growth is strong enough that an interest rate cut by the Federal Reserve -- which would help push stock prices higher -- doesn't seem to be in the cards for 2007.
  • The housing market is still in a slump, and although inventories of unsold homes continued to decline in December 2006 from a high of 7.2 months of supply, recent inventory levels of 5.9 months of supply are still well above the 4-to-4.5-month range that marks a healthy home market.
  • Low oil prices, which have helped increase profits in industries such as airlines and have given consumers more spending power, could come to an end when the peak summer driving season arrives with its big surge in demand for gasoline.
  • And, of course, stocks aren't cheap, with the S&P 500 trading at roughly its average long-term price-to-earnings ratio.

These worries are absolutely real, and that is why I'm cautious. If I can't find bargains right now, I'd be perfectly comfortable selling into this rally whenever a stock hits my target price. I'd certainly like to have some cash on hand as we head into the second half of the year.

Watch for the Summer Slump

Seasonality turns against stock investors in May and sinks until it hits a bottom in September. February is, on average since 1950, a down month for the S&P 500, according to the

Stock Trader's Almanac

. But March and April have produced a 1% and 1.3% average return, respectively, since 1950. May's average return is just 0.2%.

Many of the worries in my list above are likely to have more effect in the second half of 2007 than over the next few months:

  • Oil prices typically don't climb much in the shoulder season, when refineries make the transition from winter to summer products.
  • The Fed is likely to keep interest rates on hold for the first half of 2007, pushing off any surprise rate increase to the last part of the year.
  • And there's a good chance that investors are too optimistic about the speed of a housing-sector recovery. We're likely to see data weak enough to raise the fear that we haven't seen a bottom yet before we see the true recovery.

Cautious but not pessimistic, mind you. I don't think the stock market is in any danger of the kind of collapse that gives investors nightmares. However, I don't put a 10% correction in that category. A correction of that magnitude, as painful as it is, would actually be healthy for stocks at this point, serving as the kind of dip that brings fresh money in from the sidelines.

Swimming in Cash

Why not worry about a market collapse? Liquidity. The world is awash in cash. The flood shows no signs of receding. And it looks like more of that flow is headed toward equities over the next year.

The big hose of global cash flow is Japan. Japanese interest rates are stuck now at 0.25%, when interest rates are 5.25% in the U.S. and 4.5% in Europe. The gap is even larger between Japan and countries such as New Zealand, where interest rates are 7%.

So what do you do if you're a sophisticated global investor? You borrow in Japan at 0.25% and invest just about anywhere else in the world. Because you're using mostly borrowed money, your return on the small amount of your own capital that you commit to an investment is quite a bit higher than the gap between interest rates.

Buy U.S. Treasury notes and have the dollar strengthen against the yen, and


: leveraged profits. Buy U.S. stocks in the midst of a stock market rally, and


: leveraged profits. Buy an entire U.S. company, take it private and then flip it back to public buyers, and


: leveraged profits.

But what is known as the carry trade, the process of borrowing cheaply in Japan and then investing where returns are higher, isn't just for sophisticated investors anymore. Homebuyers in Latvia and Romania, to take just two examples, are taking out yen-based mortgages with interest rates as much as 5 percentage points below prevailing rates in the local market, the

Financial Times


A Safe Harbor

As you'd expect, this flood of cash drives up asset prices. The U.S. dollar is stronger than you'd expect for a country that in 2006 recorded another record trade deficit: $764 billion, up 6.5% from 2005. In fact, 2006 was the fifth year in a row that U.S. trade deficit produced a record.

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U.S. interest rates are lower than you'd expect because demand for U.S. Treasury bonds from overseas investors looking for safe yields and big leveraged profits has kept the price of the bonds high. (The yield on the 10-year Treasury note was 4.69% on Friday, compared with 6.44% at the end of 1999.)

This cash has had the effect in the U.S. stock market of supporting stock prices and prolonging the rally. Overseas investors have purchased U.S. stocks. U.S. companies have borrowed to buy back their own shares. Overseas companies have launched bids, funded with cheap debt, to buy U.S. companies. For example, when Argentina-controlled pipe supplier


(TS) - Get Tenaris S.A. Sponsored ADR Report

recently announced its acquisition of Houston-based



, the all-cash deal was funded with cash from the company treasury and from bank loans.

Will This Change?

Of course, the flood of cash won't continue indefinitely. And there's no reason that the flood has to flow into U.S. financial assets.

Let me take those two points one at a time.

First, the Bank of Japan could shut off the global carry trade by closing the gap between Japanese interest rates and U.S. and other international interest rates. But this gap is so huge that one or two quarter-point interest rate increases won't make any significant difference. In fact, a quarter-point rate increase this month or next might actually increase the flow of cash, because it would reassure those borrowers who have started to worry about an overreaction by the Japanese central bank -- say, a big, sharp increase in rates -- that might topple the whole structure of the carry market.

Because the Bank of Japan has faced such strong political position at home to even one modest interest rate increase, the odds of the bank moving to shut down the carry trade are very, very small.

Second, overseas investors and central banks may be souring on U.S. Treasuries, with their relatively low yields, but they're not moving money out of dollar-based assets. Instead, the move is from Treasury notes and bonds into mortgage-backed securities, corporate debt and U.S. equities.

The central banks of China and South Korea have made that shift in policy clear -- well, as clear as central banks ever make anything -- in recent weeks. China's central bank will manage its assets more aggressively, the bank has said, in order to get higher returns. In addition, China's pension funds, banks and insurers will be able to invest abroad, the Beijing government has announced, and will be encouraged to seek out higher returns.

Without those higher returns, there is no chance that China's pension plans will be ready for the country's explosion of old people over the next three decades. (For more on China's demographic and fiscal crisis, see my column

"China Wasting Its Huge Capital.")

Individual investors in Japan, too, have recently discovered a taste for higher returns. Kokusai Asset Management's overseas bond fund, for example, has become Japan's biggest mutual fund, and since 2005, individual Japanese investors have been able to buy, through the country's 24,000 post offices, investment trusts that own foreign stocks.

Still, Risks Abound

It's the shift in strategy by the central banks and pension funds of China and South Korea, rather than any move away from U.S. assets, that explains the December drop in net cash flows into the U.S. According to the U.S. Treasury, net cash flows were a negative $11 billion that month, meaning that U.S. investors bought more foreign assets than overseas investors bought in the U.S.

As long as the cash flows in something like the volumes of the previous months and the U.S. gets something like its recent share, I don't think the stock market is in danger of anything worse than a 10% correction in the first half of 2007.

That doesn't mean, however, that there aren't big risks in the financial markets now. It's just that you'll find them on the debt side rather than the equity side.

New Developments on Past Columns


Profit When Oil's Have-Nots Crash": In its fourth-quarter earnings report,

Devon Energy

(DVN) - Get Devon Energy Corporation Report

amply demonstrated why it is one of the oil patch's "haves." The company increased production in the fourth quarter by 7% from the fourth quarter of 2005 and added 489 million barrels of oil equivalent to its reserves.

The company finished the year with a record 2.4 billion barrels of oil equivalent reserves, 13% above 2005 reserves. Unlike a lot of oil companies recently, most of Devon's added reserves -- 78% -- came from finding new oil and gas. Only 22% came from acquisitions.

The future looks bright, too. The company's key 2006 acquisition added 169,000 acres -- and 600 billion cubic feet of proved gas reserves -- in the hot Barnett Shale natural gas play in Texas.

None of this is to say that the plunge in oil and natural gas prices from 2005 and 2006 highs hasn't hurt the company in the short term. Earnings for the quarter came in 2 cents a share above Wall Street estimates but a full 42% below the fourth quarter of 2005, a time of especially high prices for natural gas. Wall Street is now projecting a decline in earnings for 2007 because of tough comparisons with high 2006 earnings and a resumption of earnings growth in 2008.

The stock now sells at 11.5 times projected 2007 earnings and 10.4 times projected 2008 earnings. That's cheap for an oil and gas company with Devon's reserve position and exploration potential. The stock is likely to start to move up in mid-2007 as investors start to factor 2008 growth into their price targets. As of Feb. 20, I'm leaving my price target at $80 a share but stretching the schedule out to December 2007 from September 2007. (Full disclosure: I own shares of Devon Energy in my personal portfolio.)

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Devon Energy and Tenaris. He does not own short positions in any stock mentioned in this column.

Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;

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