After a stellar +26% gain for the S&P 500 in 2009 the market is set to post a solid 12%+ showing in 2010. Even with the strong profits already in hand, most signs point to more upside in 2011. Here are the top fundamental reasons for the rally to continue for a third straight year.
1) Corporate Earnings
Third quarter earnings season was one of the best in recent history. This was the main driver of stocks to rebound from the lows of late summer. The simple fact is that the health of corporate earnings has more to do with the movement of stock prices than any other measure. (If this is news to you, then perhaps you forgot that buying stocks is about buying an ownership stake in a company. And owners of companies don’t care about the “chart pattern” of the stock price. They care about the stream of earnings they will receive in the future).
So how good were Q3 earnings, you ask?:
- 3.78 stocks had a positive surprise for every 1 that was negative
- The average positive surprise showed earnings 5% above expectations
- 1.48 positive estimate revisions ratio for FY 2011 earnings. Meaning estimates are steadily moving up for the future.
- Year over year growth looks like +25.3% for Q3. But +43.1% year to date over last year.
Thanks to the strong earnings season noted above, the estimates for the S&P 500 earnings next year currently stand at $96 per share. Which means that the S&P is only trading at PE of 13.1. That is very reasonable by historical standards.
Now consider the earnings yield of stocks which is dividing the $96 in earnings by the current S&P price level. That comes out to 7.64% which is VERY attractive compared to the meager 3.4% yield on the 10 year Treasury. This last point has been another big driving force behind the rally in stocks that takes us to where we are today. And as you can see, there is plenty of room for it to reach higher valuations without being considered too pricey.
3) End of the Bond Rally
It appears that the mid-October bounce in bond rates marks the end of the 30 year bond rally. Right now rates are just floating up because odds of a double dip and deflation are very low. As the economy picks up steam, as it seems to be doing, then inflation expectations will rise thus moving rates up higher. There is also the scarier concept that if QE2 sparks too much inflation or foreign creditors don’t think we can pay back our massive debt, then rates on US debt will soar.
Even if the more sinister outlook never unfolds, here is a good reason why the bond rally party is nowhere near over…and why it’s good for the stock market.
There are millions of individual investors who have been loading up on bond mutual funds for years as a way to fight back against that “crazy” stock market. Most of these people believe that you always make a profit in bond funds. And now they are about to wake up the sad reality that indeed you can lose money in bond funds. Plenty of money in fact.
Many of these individual investors only notice what is going on when they get their quarterly portfolio statements. Since this bond rally ended in mid-October means that most of these folks don’t know that they have already lost a good spot of money in bonds.
Imagine their jaws dropping to the floor in early January when they see their quarterly statements bleeding red for the first time. Some will take money out of bonds immediately and put them back into stocks. But most will think it’s an apparition and stay the course. So when their April 2011 statement comes out and the bond losses continue, then the momentum will swing towards stocks even more.
4) Individual Investors Ready to Get Back In
Survey after survey shows that the average individual investor has been scared out of the stock market given the precipitous drop after the Financial Crisis. Then toss in this year’s tremendous volatility and you can understand why they’ve been saying “no thanks” to stocks for a while. But given human nature they won’t stay away for long. Now with the market making new highs above Dow 11,500 the media is printing more glowing headlines like “Stocks at 2 Year Highs!”
The more prevalent these messages become, the more individual investors will feel they are missing out and will start to pile back into stocks. This momentum will keep building the longer the market stays aloft and the higher the market heads.
How High Can the Market Get in 2011?
Given the valuation scenarios I shared above we can easily make it to a PE of 14 or 15 without being overstretched. And if the pendulum starts to swing away from fear and back to greed it could go to 16X earnings. So gains of 10-15% in 2011 are quite reasonable. Even greater gains will be seen if corporate earnings continue to outpace estimates.
I know there are many out there on SeekingAlpha who are still pounding the table about double dips or worse. The sad fact is that these “glass is completely empty” views of the world are not paying the bills. It’s not that I don’t think we have our share of troubles, its’ just that the preponderance of the evidence points to a moderate growth economy and greater gains for stocks. I hope that more of you will start to see this evidence and come along for the ride. (Double Dippers, please commence flaming my article now).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.