Charts: 10 Reasons to Expect a Year-End Stock Rally (Part 1)

Submitted by Wall St. Daily as part of our contributors program.

The U.S. economy’s careening toward a fiscal cliff.

Europe’s stuck in a financial abyss.

Even China’s economy, a bastion of strength for the last decade, is throttling down.

Given this less-than-rosy economic backdrop, how could I possibly predict that U.S. stocks are poised to rally as 2012 comes to a close?

Glad you asked.

As I promised on Monday, when I shared two startling delusions about the current bull market, here are 10 reasons why I’m taking such a contrarian stance.

(Hint: I saved the most important reasons for last)…

~ Bullish Factor #1: The Inverse to Joblessness is…

Higher stock prices. And, of course, more jobs.

As I’ve noted before, a strong correlation exists between stock prices and the four-week moving average of initial jobless claims. As claims fall, stock prices rise.

And claims keep falling.

The latest jobs reports put the average at 368,000 claims, compared to slightly north of 400,000 a year ago. Over that period, stocks are up 14.3%.

Between now and the end of the year, the labor market’s expected to continue improving. So as claims keep falling, stocks should keep rallying.

~ Bullish Factor #2: On the Brink of Economic Disaster? Hardly!

Third quarter GDP growth came in well ahead of expectations at 2%.

While that’s below the historical norm, it’s a step in a positive direction. And all signs point to even more positive surprises…

Take retail sales, for instance.

As I noted last Friday, they increased for the third consecutive month. That’s a trend, not an anomaly. And since the consumer is a major driver of economic activity, an upbeat consumer is good for the stock market.

Retail sales aren’t the only bright spot, though.

Consider Bespoke Investment Group’s Economic Diffusion Index.

It tracks the rolling number of economic data reports that come in better than expected versus worse than expected over the last 50 days. And it currently stands at +17.

That’s the highest reading since March 2011 – and a sharp reversal from the late summer readings.

As Bespoke says, “Either investors are not giving the economy the credit it is due, or they’re simply ignoring it.”

Either way, they’ll eventually wake up to the reality that we’re not headed for another recession, which will go a long way to ease their fears about investing in stocks.

Speaking of which…

~ Bullish Factor #3: Terrible Expectations

Individual investors are notoriously terrible market timers. They fall in love with stocks before collapses and swear off stocks before – and during – rallies.

Accordingly, we should treat individual investor sentiment as a contrarian indicator. And right now, it’s close to flashing a neon “Buy” signal.

Last week, the American Association of Individual Investors’ (AAII) bullish sentiment reading checked-in at 29.22%.

That’s well below the long-term average of 38.85% since 1987. And it’s also within spitting distance of the key 25% level.

As you can see on the chart, five out of six times that bullish sentiment dropped below 25% during the current bull market, stocks rallied over the next three months. By an average of 5.7%.

So given investors’ increasingly pessimistic outlook, we should be increasingly optimistic. It’s counterintuitive. But it’s true.

If you’re one of those people who refuse to put too much stock into sentiment readings, I’ve got news for you: Investors’ latest actions lead to the same bullish conclusion…

~ Bullish Factor #4: The Party’s Not Over Till the Cops Get Called

The time to leave a party is when it gets overcrowded. Why? Because that’s when things get rowdy and the cops are called, putting an abrupt end to the fun.

And right now, the only party that’s overcrowded is the bond party.

Since the market bottom, investors have plowed $1 trillion into bonds, according to the Investment Company Institute (ICI).

And fund flow tracker, EPFR Global, said in its latest update, “EPFR Global-tracked Bond Funds collectively posted their biggest inflow on record during the week ending October 24.”

Meanwhile, the stock party is struggling to top the turnout for Sandra Fluke’s rally in Reno, Nevada. ICI says that since the market bottom, investors have yanked a net $138 billion out of mutual funds and ETFs that invest in U.S. stocks.

And EPFR Global just reported that “redemptions from U.S. Equity Funds hit their highest level in 49 weeks.”

So, with investors still piling into bonds and shunning stocks, it’s time for us to cue up some Prince and dance like it’s 1999. Because the stock party’s not even close to ending yet.

~Bullish Factor #5: Failure is Not an Option

Individuals aren’t the only ones dramatically underweighted to equities. So are the wizards of Wall Street – hedge fund managers.

As I shared in September, the average hedge fund’s net long exposure checks-in at 42%, down from 49% in the second quarter. And it continues to hurt their performance.

According to hedge fund tracker, HFR, the average hedge fund is only up 4.8% in 2012, net of fees. That compares to a 16.4% return for the S&P 500 over the same period.

As Barron’s Joseph Checkler points out, “Hedge funds typically lag behind broader indexes slightly during years with double-digit S&P gains… But it’s rarely by this much.”

Like I predicted last month: “Eventually, hedge funds are going to have to rotate into stocks in a meaningful way just to keep up. When they do, it should naturally boost prices.”

Otherwise, investors aren’t going to keep paying high hedge fund fees. If they want to underperform the market year-in and year-out, they can hire mutual fund managers to do it for a lot less. Just saying.

Be sure to tune in for tomorrow’s column, where I’ll share the five most significant reasons I expect stocks to rally into year’s end.