Wall Street's biggest bull for 2017 outlines what would make him turn bearish

John Praveen has the most bullish outlook on the stock market next year that we’ve seen.

The chief investment strategist at Prudential sees the S&P 500 rising to 2,575 in 2017. No other strategist at a major firm forecast that the index will end that high — about 14% from current levels.

Tom Lee, co-founder of Fundstrat and the biggest bull for 2016, will release his outlook in the new year.

Praveen has been consistently been among the most bullish strategist in Barron’s year-end survey for five years running. We asked him about his bullish thesis and what would change his sentiment about the market.

The interview was edited for length and clarity.

Akin Oyedele: What are you saying to people that tell you it’s time to turn bearish?

John Praveen: Before the US elections, we were a little cautious on the market. Our target for 2016 was 2,300 at the beginning of the year. I was cautious mainly because we were going into rate hikes. The second thing was that this recovery is now in its sixth or seventh year. The bull market is getting a little tired.

I thought the election result was a game changer because both the bull market and the US economy are going to get new shots of adrenaline. We are getting a lot of tax cuts, both corporate and personal taxes, increased spending, and reduced regulation. All of that should boost both GDP growth and earnings.

The main reason why we are positive on the US market for 2017 is that we are looking for a big rebound in earnings. Corporate earnings in the last two years have been very weak in the US and globally. With the potential for business tax cuts, reduced taxes on repatriation of cash held abroad, reduced regulation — which means that your costs will come down to some extent — all of that should lead to a good earnings rebound.

Oyedele: What risks have you identified for the market next year and what would change your outlook?

Praveen: One of them is that Trump may not be able to get all of his tax cuts and spending plans through Congress. There may be a lot of gridlock with the Democrats not approving any of these things.

Second, Trump is pursuing some of the more pro-growth plans such as tax cuts and reduced regulations. If he goes on more protectionist policies, like raising taxes and things of that kind, that would be negative. If you pick a fight with China or put tariffs on China, those could be quite negative.

Let’s say that Trump actually undertakes tax cuts and increases spending — fiscal stimulus — and it leads to higher US inflation, then the Fed may be raising rates more aggressively. Right now, they have said that they will raise rates three times. But they may actually end up raising rates more than three times.

Oyedele: There’s a clear benefit of corporate tax reform on company earnings and share buybacks. How confident are you that some repatriated funds will also be spent on hiring and investment?

Praveen: There are two parts to my story. One is that the tax cuts and reduced regulations should improve corporate profits. The second part is that personal tax cuts and increased spending should lead to a rebound in GDP growth.

We are expecting that GDP growth will get a good boost because we should see increased consumer spending and also increased capex because you’d have less regulations and reduced taxes. Capex has been very weak in the US for the last few years.

Another reason why capex should be strong is that there is a recovery in oil and commodity prices. We should also see improvement in capex in the material and energy sectors. That has been a big drag on US GDP for the last two years. We are looking for around 3% GDP growth instead of below 2% that we have had for the last few years.

Oyedele: What sectors of the market should benefit from this environment?

Praveen: Financials, because of higher bond yields and higher interest rates. The possibility of reduced regulation, maybe some reforms in Dodd Frank, should also help. Third, stronger GDP growth means more loan growth.

Infrastructure spending and increased defence spending should help industrials.

The other sector that will probably do well is the materials sector because of infrastructure spending. Also, materials prices in general have begun to rebound, which means that materials-sector earnings should also begin to recover.

Oyedele: So you still see more upside into 2017 following the post-election rally in these sectors? Some strategists argue that even the post-election rally is overdone.

Praveen: The thing is that both material and energy-sector performance have been very poor for the last two years. Earnings were weak until the third quarter. So whatever you’re seeing in terms of gains is a catch up for the bad performance of the last two years.

You should probably get further gains from the materials sector mainly from the increased demand for infrastructure spending and increased GDP growth. So no, I’m not that concerned about the rally that we have had.

Oyedele: Your thoughts on the relative attractiveness of stocks versus bonds?

In the past, we used to think that valuations were a big driver of the equity market. Right now, valuations are not very attractive. Especially, the P/E multiple has risen. So markets are slightly above fair value.

In terms of stocks versus bonds, historically the 20-year average earnings yield gap was about 1.4%. Right now, the gap is 2.2% even after the rise. The yield on equities is about 4.7%, and then bonds [the 10-year Treasury] are yielding 2.5%. So the gap has narrowed, but has not been eliminated.

So, if bond yields remain at this level, the relative attractiveness is still in favour of stocks. They’re not as cheap as they were six months ago. In June, bond yields went below 1.5%. The gap between stocks and bonds was very big at that time. Now, the gap is smaller, but it is still there.

Valuations are not very attractive, but we are not yet in a bubble.

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