Citi Sees "Three-Legged Bull Case Stool"

Tobias Levkovich, the US equity strategist at Citigroup, reiterates his cautious view today, while remains constructive for the first half of 2010:

Bulls calling for more upside in equities rely on three specific rationales. Following several weeks of one-on-one institutional client meetings, it is very evident that there are three particular reasons that give investors confidence that share prices could rally further this year despite the powerful move off the March lows. While some of the pushback to our near-term caution has abated as markets have waffled, the tone/hope out there is still for another equity market run by year-end.

Earnings seem poised for even more gains. Given that cost cutting has been the driver for earnings surprises and estimate beats the past two quarters, likely top-line growth in the next several quarters (based on lead indicators from credit conditions and weekly data) should generate impressive operating leverage and thereby propel EPS above general investor expectations. To some degree, that view is being presented aggressively by bulls who envision better-than-expected margins to be sustained into mid-2010.

The M&A wave is beginning and thereby drive valuations higher. Given a few high-profile transactions, many investors seem hopeful that a new wave of deals will drive up valuations. Yet discussions with private equity firms and merger lawyers suggest that the bid/ask spreads are too wide now and that acquisitions may only come to the fore in a meaningful way in another six months and therefore are not yet imminent. As such, a near-term boost to share prices from this source is unlikely.

The mountains of liquidity support further appreciation. Distortions about liquidity measures are everywhere from commentary that the Fed is “printing money” to misunderstandings about calculating cash on the sidelines. Moreover, two market collapses in less than a decade probably has left retail investors feeling burned and more willing to protect principal by sitting in cash.

Our constructive view is based on volatility and earnings but pullbacks are normal. Our lead indicators on volatility suggests that the recent jump in the Volatility Index (VIX) to 30 from 20 is overdone and some easing should be expected into 2010 while earnings can support additional appreciation early in 2010 based on our margin predictors. However, one should not expect the numbers to necessarily manifest themselves within the next eight weeks, as is the seeming conventional wisdom for the late year rally effort.

Interestingly, but many factors that supported the rally so far this year are now distortions, misunderstandings ... and who cares about sustainability going forward, first of all?

Suddenly, velocity of money appears in the Citi's vocabulary. Click on pictures to enlarge, courtesy of Citigroup Global Markets.

Just to remind, the market is anticipated to run as follows:

Thus, while we could see the S&P 500 reach 1,200 during the first half of 2010 up from our year-end 2009 target of 1,000, we expect it to slip back to 1,100 by year-end. We suspect that many bulled-up investors do not want to hear or heed this message, but the data we track including sentiment is not as favorable for the moment.

But do not take it for granted! They do not operate markets for our benefit!