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The stock market continues to defy gravity and expectations in the first quarter, even as important segments of the economy remain tightly tethered to earth, is how one major publication started off an article suggesting that the stock market is heading for another bubble. It is absolutely correct that everything isn't back to the way they were just a few years ago. (We are surely better off without no-document mortgages.) While all the economy's travails are not behind us, it doesn't take much analysis to appreciate that many conditions that provide the foundation for rising stock prices are vastly improved. It is our judgment that the stock market's recovery is very solidly based and we expect more gains over the balance of the year. There may be a bubble out there, but it has afflicted the bond market, not the stock market.

S&P 500 companies beat analyst estimates by 72% in the first quarter. Bears dismiss this as just one-time cost cutting that cannot be sustained. However, more than 70% of S&P companies also reported revenues that beat estimates. As one retailing analyst noted in response to strong sales in March, This really seems to herald the end of the consumer spending slowdown. Business has picked up enough in vacation travel that cruise companies have cut discounts. The listing of anecdotes could go on forever, but the data now show rising spending by households and companies in most categories.

Analyst estimates of earnings have been consistently too low, but if the S&P 500 earns around $80 in 2010, as predicted, then the current price earnings multiple for the index is just 15, dramatically below normal for a period associated with low interest rates and low inflation. Companies are estimated to be sitting on more than $1 trillion in cash. A larger fraction of total market value is made up of cash than ever before. As companies put some of that cash to work, they will raise dividends, invest in themselves, buy back shares, or try to buyout their competitors. M&A activity has already picked up quite noticeably. Companies would hold their cash if they thought the stock prices of their competitors were too high.

The market rally off the lows has garnered very little respect. The dramatic decline in stock prices in 2008 reflected the prospect of a meltdown of the financial system and the economy. There was panic. So the simple fact that the system didn't disintegrate justified a sharp recovery in prices. Even now, stocks have room for yet more gains.

(c) Advisors Capital Management

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