If you find yourself confused about the current economic and financial environment, you’re not alone. Most of the professionals that I know, meet and talk with are likewise on edge, with most not sure if they are supposed to think the market is cheap and going higher or expensive and going lower. 

I have told my subscribers the bear case as articulated by pioneering and influential technical analyst Tom DeMark a couple of days ago, and he was on CNBC on Wednesday in a quick segment saying the same (video). And no one should “fade” DeMark without a very good reason — his work is unique, he’s super-smart, serious and has a great track record.

However, I don’t want to leave you with the impression that all of the smart money types are thinking along those lines. 

Last Thursday, I received a note from Craig Drill, a veteran hedge fund manager who rarely talks to the media but is highly respected for his historical perspective and sagacity on economic matters. He thinks that the market will roll higher over the next few years, returning to 12% annual returns, as investors become more comfortable with a lower growth environment and start to give stocks higher price/earnings multiples. 

Here is a long excerpt from a piece, presented with permission, written by one of his analysts, Steve Reynolds. I added bold to call your attention to the main conclusions: 

“Despite the recovery in the economy and a robust stock market, a lack of conviction lingers among market strategists over the longer run outlook for U.S. equities.  They are having difficulty gauging two determinants of future stock prices: earnings and price/earnings ratios.  Greater government intrusion has increased uncertainty.  Recollections of recent near death experiences have heightened levels of anxiety.  Many are afraid of their own shadows.

There is an uneasiness regarding the economic recovery’s over-dependence on promiscuously low interest rates, a flood of liquidity, consumption enticers (”cash for clunkers”), and benefit extensions.  While the quantity of activity has been adequate, there are concerns that its government-centric dependence taints its quality…

The consensus outlook for the economy is that — as the result of the headwinds of deleveraging, federal, state and local deficits, high unemployment and depressed housing prices — GDP growth will be sub-par (at 3%) for the foreseeable future. With U.S. corporate profit margins currently at historic highs, the most likely outlook is for stable to moderately declining after-tax rates of return…

Against this backdrop, in order to achieve a robust bull market with annual equity returns in high single or low double digits, an expansion in the price/earnings multiple is necessary.  On the surface, this seems problematic given the memories of the financial crisis, concerns over a sustainable recovery, and out-year government deficits and debt. … The massive and often unorthodox government responses to the financial crisis have left investors with the potential of negative consequences in the out years…

Given the size and complexity of the ”innovative” monetary and fiscal policies undertaken globally since 2008, investors must assume that the probabilities of financial/economic accidents are meaningfully elevated.  As a result, they are currently demanding a higher risk premium (lower price/earnings ratio) on equities… 

Large portions of the government’s stimulus programs have been aimed at increasing consumption and, while successful in providing short-run spurts in activity, have not been effective in generating balanced growth.  Policies crafted to stimulate business activity and private credit growth have been lacking.  

Fortunately, the administration’s recent more centrist moves and the rebalancing of Congress are likely to help boost business confidence.  Private credit growth should then follow.

Weaning the economy from its dependence on the growth in government debt will be viewed very positively by the markets.  It will usher in the first phase of a multiple expansion for U.S. equities.  It is likely that current valuations would expand over the next few years, as confidence grows that the hand off from public to private financing is underway. From 13X to 15X?…

If we look back to 1974-75, a prior period of extreme financial strain, market multiples were depressed at 7-8x.  Assuming a similar P/E in 2020 and annual earnings growth of 5%, that would imply a market with a present value well below the current level.  The fear of the continued lack of government discipline weighs heavily on the ability of the market to attain higher current valuations.

With the recent shift in political winds towards more conservatism, prospects for social security adjustments, health care cost containment, and pension reform are more likely. With the financially strapped states leading the way, changes at the federal level will become more palatable to the electorate.  

As the result, there would be a moderation of negative investor sentiment and the waning of fears of fiscal Armageddon. P/E multiples would undergo a second phase of expansion in the 2012-2015 period, possibly from 15x to 17x.

If during the next five years S&P 500 earnings grow at 5% per year and sell at the expanded P/E and if in a more confident environment dividends are increased to a 3% current yield, the annual total return on equities would be 12%.  This would be a well above consensus expectations, prolonging the market advance that began in March of 2009.

With the necessary preconditions of increased business confidence and more conservative social welfare policies gaining traction, a higher quality economic environment will evolve. Investors will no longer dwell on the carnage of the recent crisis or be paralyzed by the prospect of future fiscal deficits, but will be buoyed by the persistency of an ongoing bull market.”

For more insights like this, check out Jon Markman’s daily short-term newsletter, Trader’s Advantage, and long-term investment letter, Strategic Advantage.