Last week, the Dow Jones Industrial Average hit a record high on Tuesday and proceeded to tack on gains for the rest of the week. This move, which also saw solid gains in other U.S. stock market indexes, has to beg the question: with the broad stock market (as measured by the S&P500) now up 129% from its low of four years ago, are stocks still attractive?
The answer is yes – but clearly not as attractive as over most of the last four years, simply because they are not as cheap. Five reasons to still like (but not love) stocks are:
(1) The Stock Market is Cheaper than at Previous Peaks
Last Friday, the S&P500 closed at 1,551 compared to 1,565 in October 2007 and 1,527 in March of 2000. However, the forward P/E on the market is just 13.4 times compared to 15.2 times in 2007 and 25.6 times in March 2000. Equally important, 10-year Treasury yields are substantially lower and dividend yields are higher than in either of the prior peaks.
(2) The Economy is Weathering Washington
While investors have been justifiably worried that the combination of the big tax hikes of January and the Sequester in March could lead to an economic slump, so far the numbers are reassuring. Last Friday’s Jobs report was unambiguously positive with 236,000 jobs added, a decline in the unemployment rate and good gains in both wages and the length of the workweek.
The week ahead should also provide some reassuring numbers. Inflation measures, including Import Prices on Wednesday, Producer Prices on Thursday and Consumer Prices on Friday should all be boosted by the February spike in gasoline prices. However, this price spike now appears to be easing off and other numbers, including Retail Sales on Wednesday and Industrial Production on Friday look set to deliver solid gains.
Wealth effects may be very important in immunizing the economy from fiscal drag. According to the Federal Reserve, the net worth of the household sector rose by almost $5.5 trillion in 2012 and, based on current trends in home prices and stock prices, may have tacked on another $2.8 trillion in the first quarter of 2013. This increase in wealth appears to be helping the economy weather significant fiscal drag and could set the stage for faster economic growth in the second half of the year.
(3) Confidence could Help Multiples Expand
While higher home prices and stock prices are helping support consumer confidence, Americans still appear pretty gloomy. In February, the University of Michigan number was 77.6 compared to a 35-year average of 85.3 while the Conference Board number was at 69.6 compared to a 35-year average of 91.5. This is important for investors because there is a strong historical correlation between consumer confidence and P/E multiples. If an improving economy boosts consumer confidence over the next year or two it could well also boost the price investors are willing to pay for a stream of earnings.
(4) Global Economic Growth is Slow but Not Collapsing
The latest round of PMI data confirm that, while the global economy is certainly not booming, it is still clearly on a growth path. In particular, while Europe continues to wallow in near recession, China appears to have picked up some momentum in recent months and Japan is, at least temporarily, looking stronger. For investors, the main point is that the “tail risks” of a financial crisis emanating from Europe or a crash-landing for the Chinese economy, appear much less likely than a year ago.
(5) Higher Rates don’t Necessarily Mean Lower Stock Prices
Finally, some people have worried that an increase in interest rates must necessarily hurt the stock market. However, a look at the historical relationship between interest rates and stock prices and a consideration of where we are today makes this far from certain. For one thing, it is by no means certain that rising interest rates will slow the economy – in fact, by encouraging lending, boosting interest income, and giving buyers an incentive to finance purchases ahead of higher rates, rising rates might even boost economic growth.
More importantly, while mathematically an increase in long-term interest rates reduces the present value of future dividends and capital gains and thus reduces the “equilibrium” value of stocks, stocks are priced far below that equilibrium value right now. If investors get to love bonds a little less and love stocks a little more, then the market value of stocks could easily rise, even as their “equilibrium” value falls.
Not that this is a time to fall in love with stocks – far from it. Back in March of 2009, investors could have bought the overall U.S. equity market at a single-digit lagged P/E ratio. Today, we estimate that this P/E ratio has risen to a little bit above its 60-year average. Back then, 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 assumptions yield a 6.6% annualized return. This is why we still like but no longer love stocks.
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