A year ago this week, the S&P 500 bottomed out at 1267 on Monday, June 4, 2012. The Page 1 headline in The Wall Street Journal that day was: "Investors Brace for Slowdown…Global Economic Worries Deepen." As I opened the paper to read the dismal news, my wife asked, "What do they want us to worry about today?" When I showed her the paper, she said, "Haven't they been saying that for five years?"
That gave me the idea for the blog I wrote that week Today's Big Worries Could Spark a Flash Rally. I concluded the piece by stating, "Whenever headlines are gloomiest, like now, smart traders buy…." Since then, the S&P 500 is up about 28%, so can I claim some market-timing credentials?
Another Day, Another Depressing Headline
A year later, on Tuesday, June 4, the Page 1 Wall Street Journal headline above the fold was: Weak Signs for U.S. Output: Factories Suffer Worst Slump Since End of Recession. The article cited a decline in the Institute for Supply Management Purchasing Managers Index for U.S. manufacturers, from 50.7 in April to 49.0 in May, the first decline since November - subject to later revision, of course.
But - even if those numbers bear up over time - I believe this week's market sell-off is premature. Traders only had to wait 24 hours to hear the other substantial part of the story. Factory output represents only 12% of the economy, and we have gradually delegated a lot of that drudge work to China, Mexico, and other lands, thereby lifting their standard of living, boosting global productivity, and raising billions out of poverty.
Sure enough, on Wednesday morning, we learned that the ISM non-manufacturing index, representing 88% of the economy, rose from 53.1 in April to 53.7 in May, above the consensus of 53.5. In addition, new orders rose from 54.5 to 56.0, and business activity rose from 55.0 to 56.5. This data is supported by the fact that consumer spending last quarter was the strongest of any quarter since the 2008-09 recession.
Hold the presses, there's more. During the same monthly transition (April to May), consumer confidence rose to its highest level in over five years, leaping from 69.0 in April to 76.2 in May. The "expectations index" (our hope for the future) rose even faster, from 74.3 to 82.4, while the "present situation index" rose from 61 to 66.7 (the highest in five years, since May 2008). I could add positive numbers on housing and jobs, shrinking federal and state deficits, and our coming energy independence, but you get the point.
There is a silver lining in most dark clouds, but the pessimists mostly see dark linings in the white clouds of an otherwise sunny sky. Another example from this week: On Monday, June 3, the Page 1 Journal headline was Deficit Deal Even Less Likely (a dark lining), with this rosy subhead: "Improving U.S. Fiscal Health Eases Pressure for a 'Grand Bargain' Amid Gridlock." In other words, the real story is that a much-lower-than-expected federal deficit means that some Congressional Grand Bargain (a truly scary idea to many of us) is less likely. An alternative headline could have been: "Growth Trumps Gridlock."
I'm not picking on The Wall Street Journal. I love the paper. It is more positive than most, but it also knows that bad news sells. It gets the adrenaline flowing. People slow down and rubberneck when they pass a roadside accident, and super-violent movies dominate the movie box office most summers.
A Fresh Look at S&P Earnings Reveals More Room for Growth
A May 19 article in The Wall Street Journal featured a headline: Is This the Best Time for Investors? Don't Bet on It. Author Brett Arends examined Robert Shiller's study of the 10-year average inflation-adjusted earnings of the S&P 500. The article concluded that the S&P is trading at a lofty 23.7 times 10-year inflation-adjusted earnings vs. a historical norm of 16.5, implying that the market is 44% overvalued.
Never mind that the S&P currently trades for less than 15 times earnings using simple math (an S&P reading of 1620 vs. $111 in 2013 earnings). The article also ignores the fact that the long-term average price-to-book ratio is 2.77 vs. a current reading of 2.49, implying that stocks are 10% undervalued.
Another flaw in the P/E logic is that earnings are rising, dragging the bears, kicking and screaming, along with this relentless bull market surge. Argus Research, in its June 2013 monthly update says, "Rally Likely Won't Top Out at Current Valuations". It pegs 2013 S&P earnings at $110.80, rising over 10% to $122.50 in 2014. At 15 times 2014 earnings, this implies an S&P of 1837 within a year, but a higher P/E ratio is justified in a low-inflation environment. Using the "Rule of 20" (20 minus the CPI or 10-year T-bond), a modest 17 times 2014 earnings would take the S&P over 2080 (up another 28%) by mid-2014.
If you want to talk about market peaks, Argus looked back at the last seven bull market peaks and found that the average P/E ratio when the market topped out was 20.9, so it seems we're a long way from the thin ice.
Looking to the rest of 2013, analysts currently expect S&P earnings growth of 7.8% next quarter and 13% in the fourth quarter, based on easier comparisons to weak earnings growth in the second half of 2012. This would bring S&P quarterly earnings to $29.38 in the fourth quarter - an annual rate of $117.50.
Stocks are Seemingly Still the Best Game in Town
We have yet to see any mania in stock buying. The average investor has finally dipped his toe in the stock market after four years of hiding under the mattress in low-yielding cash and bonds, but the global bond market still dwarfs all global stock markets. GaveKal Research says that $156 trillion (75%) of the world's $209 trillion in financial assets is debt-based - investing in bonds or loans. With interest rates finally starting to rise, this capital seems to be misallocated for future capital gains and maximum safety. As interest rates rise higher, we may see a huge exodus out of this debt-based pyramid, back into stocks.
Ever since long-term rates peaked at 20% in 1980, the price of bonds has risen as long-term rates have fallen. Stocks have also seen a great 30 years, but they suffered a "lost decade" from 1999 to 2009. The data from Investment Company Institute (ISI) shows that equity funds are finally popular this year. Bond funds also saw a net increase through April 30, but 10-year Treasury rates rose 50 basis points in May, from 1.66% to 2.16%, so the long-awaited Great Rotation out of bonds may finally begin later this year.
If you look at long-term trends instead of daily data points, the case for stocks grows even stronger. For instance, demographics favor U.S. stocks. The other rich economies - primarily Japan and Europe - are not having children. America is the only rich country whose population is still growing. We add about 1% to our nose count (3+ million) each year, mostly due to immigration. A growing population engenders consistent long-term growth in industries like construction and retail sales. Adding more young workers is also the only viable way to fund Social Security and Medicare benefits for aging Baby Boomers. So take a moment to notice babies, blue skies, and balance sheets of U.S. corporations.
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