Tim Mullaney: Does this market have another 10% to run?

Most of the time, when Very Serious People talk about stocks they affect a chin-strokingly serious mien of caution: Hmmm, says the Very Serious Person, the economy might be good, but stocks are mighty expensive as the Dow Jones Industrial Average

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 crosses 23,000 and you never know what might happen to interest rates.

Into this pre-Halloween cauldron of caution wades Credit Suisse strategist Jonathan Golub, who says the 13% rally in the Standard & Poor’s 500 stock index

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 this year will be followed by another 10% or 11% next year, taking the S&P to 2875. At the risk of my own Very Serious Person card, he may be right.

But the argument depends on the Federal Reserve, and whether it responds to the first signs of an economic recovery worth celebrating by taking away the punchbowl before the party rocks.

To gain a handle on what’s happening to stocks, you need a view on two things — corporate profits, and how fast rising interest rates will erase the spread between stock and bond values that has pushed stock valuations higher. Golub argues that the market’s 19.7 price-to-earnings ratio is reasonable — even a little low — which is what makes his view provocative,

“Historically, P/Es rise throughout a recovery, declining viciously into an economic contraction,” Golub writes. “With recessionary risks contained, volatility depressed, and [corporate bond] yields at 4.4%, we see upside to multiples.”

The math of Golub’s 2875 call is straightforward: The 10%-11% annualized gain in stocks over the 15 months will come mostly from a 6% to 7% climb in earnings. About 1.5 percentage points will come from stock buybacks reducing the number of shares companies have. And the rest will come from further growth in stock multiples, he says — the most controversial part of his thinking.

Golub has two core ideas, both related to interest rates.

One is that low interest rates mean stocks are worth more because bonds become less competitive. Most people believe this, but quibble about details of how wide spreads should be.

By Golub’s math, today’s yields mean stocks should be worth about 23 times earnings, because the expansion is likely to last a long time yet and has been accompanied by historically low volatility in stocks. He also thinks profits have more room to rise than the market realizes: Profits look like they’re near a top because companies are spending so little on interest expense, but operating profits are lower than in past peaks, he argues. That means operating profits can still move higher.

The other is that interest rates will rise, but only slowly. This is where it gets more controversial: The trendy idea right now is “reflation,” the notion that a boost in inflation and growth will boost some stocks but also prompt the Federal Reserve to raise rates more sharply.

The Fed certainly seems to believe this — or at least to think its responsibility is to raise rates quickly to stave off inflation. Yet, the evidence for the reflation theory is still weak — and points to rates rising less rapidly than the Fed has indicated. And Golub’s theory depends on bond yields staying fairly weak.

September’s inflation and employment data are being pointed to as evidence of inflation picking up, but each falters under close examination.

Inflation picked up last month — because energy prices surged after hurricanes hit Texas and Florida. Core inflation — the kind the Fed worries about, excluding food and energy — is still only 1.5% for the four quarters ending in June, well short of the Fed’s 2% target.

Even 2% inflation isn’t an electric fence shocking us into recession the moment it occurs: The Fed’s target is a goal for inflation over an economic cycle, running a touch hotter when the economy expands. The central bank only needs to crack down if inflation is going to another place entirely — and there’s no sign that’s happening.

Indeed, there hasn’t been a year since 1993 when core inflation topped 2.25% for a full year. So even if inflation nudges up by half a percentage point, that’s not evidence we’ll be papering our walls with currency. There’s a long lists of reasons — low capacity utilization and remaining labor market slack top it — why inflation’s contained.

That’s why it’s also best not to make much of the 2.9% year-over-year gain in average hourly compensation the Labor Department reported for September. It’s the first gain that large — year-over-year gains have been 2.5% for most of 2017. Middle-class wages are supposed to rise strongly late in economic cycles — they usually rise faster than this, and middle-income workers have only recently recovered real compensation they lost in the 2008 recession and its aftermath. It’s a good thing, not a problem.

The Fed has running room on inflation to raise rates slowly, if at all. It’s good for workers, who still need a break. And it’s the right strategy for the markets. Golub’s theory, for one, depends on it.