The Biggest Threat To The Stock Market Rally

Derrik is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

As the Dow reached new heights over the last few weeks, we have heard many outlooks on how it's going to come to an abrupt halt. Sell in May go away is around the corner, Cyprus uncertainty sending negative reverberations, quantitative easing creating hyper-inflation and many more.

But as consumers, we must pay attention to the multi-versed views of economists around the country. Admired professor Jeremy Siegel recently proposed his view on the current market conditions. He believes in the concept of multiple expansions, which is a fancy way to say that investors will pay more for a dollar's worth of earnings. The Great Reflation experiment currently being conducted by the world's central banks have left investors with few options to generate returns. So who is the biggest threat to the current market rally? Ben Bernanke.

The Federal Reserve Chairman has consistently stated that the cost of the quantitative easing program is unknown. Essentially, he's saying that excessive money printing can create a high inflation environment, but he doesn't want to admit it. The threat that inflation could run hotter than desired is a primary concern for equity investors. Contrary to popular belief, stocks do not outperform during periods of high inflation. Multiple expansion only occurs during periods of stable prices. The following chart depicts the S&P 500 P/E ratio and the year-over-year percentage change in CPI.

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Source: BLS and Bloomberg

It is clear to see that as inflation rises, the P/E ratio actually falls - or in decorative language - multiples compression. The key level to watch is roughly a 4% year-over-year change on CPI. It is at these levels that investors are no longer willing to pay more for a dollar of earnings. There are two possible explanations for this behavior: 1) investors begin to anticipate central bank tightening and/or 2) investors use the higher expected rate of inflation to discount future earnings, thus reducing the present value of those earnings. Regardless of the explanation, the fact remains that rates of inflation above 4% tend to lead to a lower P/E ratio, and this is where Chairman Bernanke comes in.

With the most recent Fed minutes making investors think twice about the duration of quantitative easing, Bernanke is the single biggest threat to the stock market rally. Chairman Bernanke has a tiny needle to thread - he must convince investors that quantitative easing will create just enough inflation to make multiples expand while also guarding against the inflationary consequences of hyper-expansionary monetary policy. The margin for error is slim. As investors, we must constantly be attentive for the catalysts that could reverse the current paradigm. Luckily, the actions of the Federal Reserve have suppressed volatility, providing investors an opportunity to buy low cost insurance. The CBOE Volatility Index is approaching historic lows which means put options are cheap. While Bernanke poses the biggest threat to the stock market, it is critical for investors to pay attention to these fundamental indicators

What Stocks To Watch

Given the aforementioned conditions, some of the stocks will benefit and some will react negatively. Here are some options to consider over the next few weeks:

Caterpillar (NYSE: CAT) is an excellent option to consider in the future. Despite missing analyst estimates in it's most recent earnings report, the company is fundamentally very solid and has price-to-book ratio of 3.01x - one of the lowest in the construction industry.

Still, trading near its 52-week low, the stock was up as CEO Doug Oberhelman said he thought mining purchases had hit bottom, and pointed to an increase in sales in China as another positive. The  company also plans to buy back about $1 billion worth of shares, its first such program since 2008. In an inflationary money environment where the buying power of the dollar decreases, natural resources historically have flourished, which in turn will increase the demand for mining and mining equipment - making this construction giant an appetizing option to watch. 

Home Depot (NYSE: HD) has outpaced its top rival Lowe’s Company after Chief Executive Frank Blake in recent years unveiled several initiatives including using technology to free employees from tasks to improve customer service and made distribution more efficient. Both companies, however, have seen a boost from a recovery in the housing market. The company recently reached a 52 week high, and has strengths that can be seen in multiple areas, such as its impressive record of earnings per share growth, compelling growth in net income, revenue growth, notable return on equity, and good cash flow from operations. Home Depot was one of the few stocks that actually benefited from the recession. During the boom years, houses were going up extremely fast, and some were being built at substandard quality to make the building process move quicker. As a result, these houses needed to be repaired and maintained. Not to mention the amount of foreclosed properties sold that needed major work. As the housing market recovers, and banks continue to unload distressed properties, the repairs will continue, and so will Home Depot's profits.

McDonald’s (NYSE: MCD) sales declined 1% in the first quarter, in line with analyst expectations, as the chain continues to get hurt by the global economy. In the U.S., its same-store sales were down 1.2%, but McDonald’s said that, “despite these results,” it “outperformed the competition and increased market share” in the U.S. Even in a declining market, consumers will always buy a cheeseburger and coke, regardless of the fiscal conundrum. Investors should keep an eye on McDonald's and their growth initiatives, as they recently announced that they would opening chains in Russia in the coming years.

The Bottom Line

The above companies are excellent options for any value  investors looking for stocks with solid fundamentals, and a history of weathering stock market declines. Ultimately, if a company is solid from the core and has a strong management team leading the way, it will always continue it's uptrend despite the economic forecast. 

Derrik Lattig has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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