The headlines continue to remind investors that the financial markets have sustained a bull rally without a bear in sight. The perception among investors is that there is more reward than risk. The day before Good Friday, the S&P 500 surpassed its previous bull market peak reached on October 19th, 2007. After inflation, the market is still ten percent below the 2007 peak, but that deficiency is almost exactly made up by dividends paid by the index so that the total real return for stocks over that period is also almost exactly zero. Regardless, the benchmark index is still well below its March 2000 peak in real terms even counting dividends. Over the past 13 years there has been a 30% nominal return (including dividends).
Although, the markets were closed last Good Friday, the government did release personal spending and income for February and the numbers were robust, prompting some economists to revise the GDP growth estimate to 3.5%. The final University of Michigan Confidence numbers were also revised up sharply to 78.6% from the preliminary release. And core PCE inflation in February remained at a low 0.1%, yielding a 1.3% year-over-year rate, far below the Fed’s threshold for tightening. This data means that the market is set to extend its gains to start April.
April is historically the Dow’s best month and I present several reasons why I expect the rally to continue:
The stock market is cheaper than at previous peaks.
New technology is alive from Silicon Valley to Silicon Alley – the Cloud, Smartphone, Tablet, Fracking, and 3-D printing – is boosting growth and creating record levels of profits.
The U.S. economy is tolerable of Washington.
Consumer confidence is growing – which will lead to an uptick in spending.
Global growth is slow but not collapsing.
Higher rates haven’t arrived while stock prices keep rising.
Housing remains a key source of strength.
Demand for mortgages has been strong.
American’s overall debt service costs as a percent of disposable personal income are now at the lowest level they’ve been since at least 1980.
ECB Chief Draghi’s promise to do “whatever it takes” to shore up Eurozone sovereigns has put a lid on rising bond yields in the currency union’s peripheral economies calming the fears of contagion and a potential break-up.
“Main Street” investors want to play in the game.
The U.S. markets are on center stage. It’s where capitalism lives.
Back in March of 2009, investors could have bought the overall U.S. equity market at a single-digit lagged P/E ratio. I started discussing a “V” shaped recovery with my clients. My thinking was pretty simple. We will get to the right side of the V but it could take a 5-7 year market cycle. And, last week, the S&P 500 reached an all-time record high close – in other words, the right hand side of the V has been topped off.
In fact, I predicted that the S&P 500 would hit 1500 by the end of 2012 – and my prediction lagged only one month to reach that level.
Today, I estimate that this P/E ratio has risen to a little bit above its 60-year average.
In 2009, an assumption of 5% earnings growth, a 2% dividend yield and a return to average P/Es implied a roughly 15% annualized return over 5 years. Today the same set of assumptions yields a 6% – 7% annualized return.
Of course, these assumptions are optimistic. Moreover, it should be stressed that even an annual return of 6% or 7% per year is good in an investment environment of very low yields on bonds or cash. However, given a year’s worth of respectable gains that we have already seen in Q/1, I believe that investors should be focused on having a balanced approach to investing, appropriate for their time horizon and risk tolerance, with only a slight overweight towards U.S. stocks relative to that balanced approach.
Some are accustomed to the gains as the new normal; others call it a new sugar high, while still others are convinced that it’s all just a new bubble due to the Federal Reserve pumping all the liquidity into the system. I expect the rally to continue with a slight pullback that will occur at some point during the forthcoming quarterly earnings season which kicks-off next week.
Moreover, I believe the growth is real, it’s now, and we should enjoy the green arrows but remind ourselves of how quickly they can turn red.