Market valuations relative to earnings performance are still below the bull runs of recent decades. That indicates that stock prices are unlikely to drop much and that benchmark indices are in a position for additional runs higher.
Reasons for Optimism
It is easy to get caught up in the hype and headlines that focus on the S&P 500's move into uncharted bullish territory. The post-credit crisis gains have been massive: The bull market in U.S. stocks has been in place for five years, with the S&P 500 surging nearly 145% from the 12-year lows posted in 2009.
Improvements in investor sentiment have been driven largely by strong corporate earnings -- albeit relative to weaker analyst expectations -- and three rounds of quantitative-easing stimulus from the Federal Reserve.
The Fed's pledge to buy mortgage-backed securities at unprecedented rates remains in place, as the Fed has said it will keep do so until the unemployment rate falls to 6.5%.
Investors should also be mindful of stocks' valuations. When we look at the tech rally of the late 1990s, some interesting similarities and differences emerge. During the last five years of the tech bubble, the S&P 500 saw gains of roughly 27%. At their highs, stocks were trading at 25.7 times earnings.
The bull rallies after the credit crisis have surpassed those percentage gains en route to new record highs above 1650.
Valuation metrics, however, tell a different story. Shares in the S&P 500 trade now at 19 times earnings, a difference of 26% from the valuations marking the dot-com rally.
So, while price gains in the benchmark indices have been similar, this time around valuations have been accompanied by nearly comparable earnings growth, unlike what happened in the 1990s.
U.S. corporate profits have risen at a yearly rate of 20% since 2009, more than double the rate seen during the dot-com rallies. S&P 500 companies have earned $785 billion in the last year, more than three times the $256 billion tallied in 1996. That should encourage investors who are long since valuations at more reasonable levels go far in validating bullish sentiment.
Bulls vs. Bears
For bears, a weaker price-to-earnings ratio in the central indices may mean that investors lack confidence in the economy. Consider the past: In the 1990s, stock returns at these levels led to a price bubble that later erased $5 trillion in shareholder assets.
But bulls are looking at more than just prices. They say rising profits present investors with a more stable picture compared with the tech rally of the 1999s. On balance, this is a bullish scenario.
So, despite the ECON101 mantra to "buy low, sell high," investors should continue to expect only limited drops in the S&P now that the index has established itself above 1600. And any drops in the index should be viewed as an opportunity to buy into the long-term uptrend.
At the time of publication the author held no positions in any of the stocks mentioned.
This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
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