Yes, The Rally Can Continue

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 |  Includes: DIA, OEF, QQQ, SPY
by: Russ Koesterich, CFA

Will the rally in US equity markets continue? While we do think equity market volatility is likely to rise this summer, we also believe that earnings and the stock market will hold up. In fact, it can move even higher in the remainder of 2011.

There are two aspects to this to focus on: margins and multiples. Many investors are skeptical that profit margins can remain near historically high levels, particularly with rising commodity and energy costs. While this will certainly hurt some companies and industries, it is important to remember that for most companies the two biggest input costs are labor and capital. Both are historically cheap and likely to stay that way.

For example, as of March, hourly wages were growing at less than 2% year-over-year. In other words, in inflation adjusted terms, hourly workers have taken an implicit pay cut over the past 12-months. With significant slack left in the labor markets, earnings are likely to remain low for the rest of the year, which supports profit margins.

In addition, companies are also benefiting from cheap capital. With the bond and commercial paper markets now open for business, large companies can bypass banks and borrow at historically low yields in the credit markets. For example, Baa rated bonds are currently costing companies roughly 6%, versus a 20-year average of approximately 7.7%. For the best borrowers, the discount is even larger. AAA bonds now yield around 5.10%, a +30% discount to their 20 year-average of 6.75%.

With respect to multiples, it is important to note that with the threat of deflation receding and large-cap valuations still modest, equities are likely to get a boost from multiple expansion or rising price-to-earnings (P/E) ratios.

Core inflation in the US remains low, but is no longer declining. This puts inflation in a good position. This should provide a boost to equities in the form of multiple expansion, which was not evident last year. In 2010, the P/E ratio on the S&P actually contracted by around 10%, at least partly a result of last year’s inflation outlook. For most of the year investors and the Fed were focused on the threat of deflation. And while investors generally prefer low inflation, there can be too much of a good thing. In those few instances when the economy has flirted with deflation, multiples have generally been below average.

Today, with the threat of deflation receding equity markets are benefiting from low but stable inflation. With core inflation now climbing above 1%, inflation is now in the range which has historically produced the highest equity multiples. In the past, when core inflation has been between 1% and 3% the S&P 500 has traded at an average of 19.5 times trailing earnings. If core inflation remains muted in 2011 – as we believe it will – and with the S&P 500 trading at around 16 times trailing earnings, there is room for further multiple expansion in 2011.

While we don’t believe that this benign environment will last indefinitely, to the extent wages, interest rates, and core inflation remain low for the next 12 months, there is room for further stock market gains. In this environment, within the US equity market investors may want to consider mega caps in particular (NYSEARCA:OEF).

Source: Bloomberg