By Mark Melin 

As the S&P 500 is nearing the “top end of its range,” two courses of action could take place. The US large cap benchmark could stall and mean revert, or – to the delight of market bulls – it could mean a stock market breakout. BCA Research is in the latter camp, thinking a “playable breakout looks increasingly probable,” but “the exact timing is difficult.”

Stock market breakout – Goldilocks moment?

In active trading, it is not just getting a market call correct that matters. The timing of a prediction is critical and sometimes considered a more difficult component of the overall thesis. It is here, against a tightrope act, that BCA weighs in with a May 1 report “Girding For A Breakout.”

b1-foto / Pixabay

Amid a first quarter GDP that showed a weaker than expected 0.07% print and conflicting strong April jobs creation numbers of 211,000 released Friday, the macroeconomic picture is not entirely clear.

BCA, for its part, notes a strong underpinning to the market that is starting to look like a Goldilocks market: not too strong to keep the Fed from being overly aggressive, but not too weak to hinder profit growth.

“First quarter profit results have been strong, corporate guidance has been solid and monetary conditions are unlikely to become tight enough in the short run to dent renewed profit optimism,” the Montreal, Canada-based researcher says. The recent “string of economic disappointments” is not so much a negative as it is “providing the Fed with ample leeway” to take a gradual path at raising interest rates, one that might lead to a stock market breakout.

While the economy might be exhibiting some signs of “sluggishness,” this an issue investors may need to overlook like a wart on a lover’s nose. But there is another attractive feature to consider. While top line economic growth is important, the corporations outperforming right now are doing so through profit margin expansion. It’s not entirely the economy that is the only growth factor – although that is important — but rather profitability on sales matters. “Earnings growth is supported by a broad-based recovery in sales and pricing power,” the report noted, pointing to the need to justify current price / earnings ratios. “Top-line growth is critical to sustaining the overall equity market overshoot given sky-high valuations.”

Stock market breakout- pricing is driven by relative value analysis, particularly important are interest rates

From one perspective the stock market is about relative value to other potential investments, such as bonds, real estate and credit. There is a constant risk / reward dynamic playing out, often driven in large part by interest rates, as BCA observes:

The appeal of equities stems from their attractiveness relative to other asset classes rather than in absolute terms. History shows that an asset preference shift can take time to play out, and push valuations higher than seems justified on fundamentals alone as long as recession is not an imminent risk. The Treasury market can provide clues as to when vulnerabilities will intensify. According to BCA’s Treasury Bond Valuation Model, yields usually need to be at least one standard deviation above normal before stocks, and the economy, are at risk of a major downturn

BCA monitors its proprietary valuation models in the bond market to, in part, determine the sustainability of a market move higher. Their model helps tell them if “inflation concerns are running hot” which could force the Fed to “tighten quickly to slow growth and undermine economic activity.”

BCA says this “simple rule of thumb” warned of the most recent stock market peaks and equity downturns in the early 1990s, 1987 and the early-1980s. “Recently, the 10-year Treasury yield has returned to fair value, and the U.S. dollar has come off the boil,” the report said, noting the runway for stocks remains clear. “The implication is that there is no monetary roadblock to halt the upward momentum in equities at the moment. There is ample room for yields to rise before becoming restrictive, especially if the primary driver is the real component.”

In this environment, BCA likes financial stocks, upgraded from neutral to overweight, and bank stocks, upgraded from underweight to overweight. Health care stocks and their related equipment manufacturers were downgraded to neutral.