We have returned our Market View to Moderately Bullish.  The upside potential for the market has not improved significantly.  The risks, however, have declined.  Decent valuations and continued earnings growth should allow the market to end the year higher.

Reduced Downside Risks

The key change in our view is that the downside risk to the stock market has been significantly lowered as a result of the Fed's action to cut the fed funds rate target 1/2%. 

The Fed clearly intends to act to avoid recession.  The fear of recession had produced an abnormally high risk premium on stocks that should now dissipate.

There is still a risk that the liquidity problems on Wall Street turn into a credit crisis that hits the broader market.  In our opinion, this risk was always vastly overstated.  This risk gets lower with each passing week as the market works through the liquidity issues. 

The market has been preoccupied with risks over the past few months.  The market has found some new fears to obsess over - a weaker dollar and inflation (noted below) - but overall, risks are declining. 

Potential Rewards Remain Constrained

The upside potential hasn't improved significantly.  Economic growth will remain sluggish and the earnings growth outlook is problematic. 

We therefore emphasize the "moderate" portion of our Moderately Bullish position.

Wall Street forecasts for real GDP for the third and fourth quarter are now at 2%.  That is down from about 2 1/2% a couple of months ago.  Housing remains a clear drag on the economy and consumer spending is rising at only a moderate pace.  Even with the rate cut, real economic growth is a ways from returning to the long-term trend of 3%.

That leaves the longer-term earnings outlook as merely decent.

Third quarter earnings are expected to be up about 3% over the same quarter last year.  Fourth quarter earnings should be up about 10%, helped by an easier comparison for energy companies from the fourth quarter of 2006.  Into 2008, we expect moderate earnings growth of about 5%.  That isn't great, but it also isn't bad.

Back to Value

Valuation has not been a major topic lately because it is hard to assess when the economic outlook is highly uncertain.  Current valuation means little if a recession might develop. 

Now that the rate cut raises the likelihood that the economy will remain on track, valuation should return to the discussion.  It is a supportive factor.

The price/earnings (P/E) multiple on operating earnings for the S&P 500 in aggregate is now 16.7.  The P/E has been between 16 and 17 for the past two years. 

This P/E represents a 6% earnings yield (E/P).  That is a very reasonable valuation. 

The simple so-called "Fed valuation" model suggests that the year-ahead earnings yield expectation should return approximately the same as the 10-year note.  The current 10-year note yield is just 4 5/8%.  Expectations of about 5% to 6% earnings growth the next four quarters implies an earnings yield of about 6.4%.  On this basis, stocks return about 35% more than bonds.

Stock valuations, assuming there is any kind of earnings growth over the next few quarters, are very good. 

What it All Means

The math is simple.  If the P/E multiple can hold steady, the S&P 500 index will rise in line with earnings growth. 

The P/E falls when risk increases, because the earnings growth outlook is uncertain.  We believe that risk has greatly diminished.  The P/E should hold near the current level over the year ahead. 

Earnings growth should therefore allow the market to rise at a moderate pace over the coming quarters.

This isn't a market timing call.  The market may trade sideways for a while until a classic year-end rally.  Rather, this is a change in our assessment of the longer-term reward/risk ratio.  We have had a Neutral position in the market the past three months because of higher risks.  We are now retracting that position.

The market will find new worries.  Right now, it is a rather absurd concern that the weaker dollar and higher commodity prices will spark inflation such that the Fed might have to reverse their recent action. 

A weaker dollar has the beneficial impact of improving corporate profits and the impact on US inflation is minimal.  The year-over-year core PCE is just 1.9%.  The year-over-year core CPI is 2.1%, and the total CPI sits at just 2.0% over the past year.  Inflation rates are dropping and the recent sluggish economic growth and loosening labor market will prevent any substantial rise through the end of the year.

It is time to turn back to the fundamentals rather than to obsess over the risks associated with the subprime mortgage problem or the chance of recession. 

The fundamentals support a moderately bullish view.