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Why the U.S. Equity Markets Could Still Make Further Gains

Yahoo! Finance
The Exchange

By James Short

As the stock market continues its seemingly-endless rally, many investors may be asking “how can the equity markets possibly go any higher in the near term?” The answer may surprise them.

Since the U.S. equity market’s low in March 2009, there has been a great deal of appreciation. Large caps are up roughly 150 percent while mid- and small-cap stocks are up about 200 percent. Price-to-earnings (P/E) ratios have been drifting down and current S&P 500 earnings are approximately $105, which is significantly higher than the previous peaks in 2000 and 2007. Accordingly, the current P/E multiple is well below those prior peaks.

And it’s not just the P/E ratio that’s worth looking at. The S&P 500 is below its 15-year average for the following measures: price to sales, price to cash flow, price to book and price to earnings to growth.

Furthermore, the S&P 500’s dividend yield is significantly higher today than the benchmark’s 15-year average. Additionally, levels of corporate-cash stockpiles have nearly doubled even as the vast majority of the benchmark’s constituents have fattened their dividend policies. That means dividend-payout ratios are still very low – and are certainly below their 15-year average – despite all of the recent dividend increases.

Corporate management teams remain cautious about the macroeconomic environment and consequently have hoarded cash. However, they will eventually put that cash to work in the form of corporate capital expenditures, M&A, further dividend increases or additional share buybacks.

Consumers are also minding their spending. Consumer debt relative to disposable personal income is now below its average for the last several decades. More specifically, it’s down from 14.1 percent in the third quarter of 2007 to 10.4 percent in the fourth quarter of 2012. Pessimists could argue that the valuation measures of the last 15 years are still grossly inflated due to the bubbles, but it’s worth noting that there also have been some massive corrections during the last 15 years to balance out those peaks. Valuations are still reasonable if you look at the averages since the end of World War II.

Global macroeconomic issues certainly remain. The eurozone continues to struggle with myriad issues, including sovereign-debt and labor concerns; “The Arab Spring” is now years-long; North Korea’s saber-rattling is unsettling at best; and there are questions about the Chinese economic growth rate.

Domestically, the U.S. GDP is growing but is far from optimal. The unemployment rate is down from almost 11 percent but is still hovering above 7 percent. The housing market is still historically depressed and far from the ‘05-‘06 peak (but improving from the ‘09-‘11 base), U.S. government debt as a percent of sub-par GDP has exploded over time, and entitlement and military spending continues to snowball.

Those kinds of distractions tend to keep investors – fearful of an “inevitable” significant market correction – on the sidelines, while the market climbs “walls of worry” (as demonstrated over the past four years).

As such, investors should always be considering options beyond equities. Alternatives and commodities can have a place in a broad allocation but, on their own, they tend to offer a great deal of volatility. Fixed income, the so-called “safe investment,” is equally unsatisfying, with 10-year fixed-income yields at less than two percent (witness the “feeding frenzy” over Apple’s (AAPL) recent $17 billion bond deal). Indeed, many traditional fixed-income investors may find themselves turning to stocks merely as a way to replace a paucity of yield in bonds.

A diversified portfolio of equity asset classes, tempered with bonds and other investments, has proven over time to outperform over the long term. The stock market currently has its feet under it and, more importantly, appears to have the fuel to continue its upward march. Consequently, I believe it remains worth consideration by those who appreciate the fundamentals of a sound investment strategy.

James Short, CFA, CFP, CIMA, is a client portfolio manager and senior vice president/director of institutional client services for St. Petersburg, Fla.,- based Eagle Asset Management.