NEW YORK (Fross & Fross Wealth Management) -- With equities at or near new highs in the first quarter, plenty of analysts say that the markets will run out of steam, as they did in 2011 and 2012. However, we think that the situation is fundamentally different in 2013 and that the markets still have room to run.
Despite some major headwinds from sequestration and the deteriorating situation in Europe, U.S. markets have put up an impressive performance in the first quarter, fueled by liquidity and upbeat economic reports. Earlier this month, the Dow Jones Industrial Average cracked 14,400, while the S&P 500 approached its record close. While you cannot invest directly in an index, and their recent performance does not guarantee their future returns, we are encouraged by this recent action.
Many analysts fear that the rally won't last and that we'll see a repeat of the disappointing mid-year performance of 2011 and 2012. In the short term, we agree that equities may be overbought and investors should expect a little consolidation, but we think there's plenty of room for optimism about the market rally this year.
1. This is one of the most unbelieved rallies we've ever seen, and it has hung in there despite the odds. Retail investors remain skeptical and we think that there's a lot of money sitting on the sidelines.
A look at the Investment Company Institute's statistics on money market accounts tells us that there is still a lot of cash parked in institutional and retail money market accounts that could be injected into equities.
For the rally to continue, retail investors will have to jump in more aggressively, and there's evidence to suggest that some already have. A TD Ameritrade sentiment index shows that retail investors have been buying stocks more assertively than they have in the last three years, and the latest ICI report shows that total money market assets dropped by $16.7 billion, to $2.646 trillion, during the week ended March 6, showing that investors are moving out of cash.
2. Loose monetary policy. This is the rally that Bernanke built and it looks like "QE Infinity" is here to stay. The market has been booming largely because of the concerted efforts of the Fed and central banks around the world to drive growth by forcing down bond yields, pushing return-seeking investors into riskier assets and restoring confidence in the global economy.
Investors in cash are getting a negative return after inflation, making equities look more attractive. Despite some dissension in the Federal Reserve ranks, Fed Chairman Ben Bernanke has pledged to hold the federal funds rate near zero as long as inflation doesn't top 2.5% and unemployment remains above 6.5%, reassuring investors that the party won't stop anytime soon.
3. The housing sector has been a bright spot. The housing sector is still acting as a tailwind for the overall economy. Sales of new houses are up to 2008 levels and existing housing stock is shrinking, feeding the trend. The manufacturing sector is showing improvement across industries and new orders were up in February for the second month in a row.
4. Price-to-Earnings ratios are still relatively low with respect to historic values. PE ratios are one of the ways we evaluate whether a stock is overvalued. The chart below shows historic PE ratios using reported earnings for the trailing 12-month period (TTM) of the S&P 500 from 1900 to today. The PE ratio on March 11 (calculated using the last official EPS data from 2012) was just shy of 18, only a couple of points above the historical mean of 15.49.
The S&P data are lagging and we still don't have official numbers for Q4 of 2012. However, the unofficial estimates released by Standard & Poor's show an EPS of $87.93 for Q4, and a forward-looking estimate of $89.63 for Q1 2013, well above the Q3 EPS of $86.50.
Some analysts might argue that equities are overvalued in any period during which the PE is above the long-term average, favoring mean reversion over future expectations. We beleive that this is a short-sighted view. When earnings appear to be increasing, profits are up as companies have adapted to doing more with less, and business confidence is back.
In the short term, the market may back off of these highs, but where some analysts see froth and exuberance, we see priced-in expectations and solid fundamentals. While there continue to be risks to the markets, we're with the bulls in 2013.
At the time of publication, the author held no positions in any of the stocks mentioned, although positions may change at any time.
This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.