In the summer of 2010, investors became obsessed with the idea of a double dip recession. With that, the market pressed down to Dow 10,000 with many experts looking for a lot more losses to come. From that darkest hour we saw a stunning 28%+ rally lasting the next several months.
Now here we are in the summer of 2011 and it seems that we are once again plagued by similar doubts and concerns about the economy. This has led to a significant correction with the question on everyone’s mind being: Where are stocks going from here? I strongly believe the answer is that we are due for more gains. Not just back to the recent highs, but beyond. There are several sound fundamental reasons for the market to continue its advance to new highs. Here are four such reasons.
1. Corporate Earnings. First quarter earnings season was very strong and the early indications call for more of the same with second quarter earnings season starting in July. The simple fact is that the health of corporate earnings has more to do with the movement of stock prices than any other measure.
So how good is the earnings picture?
- 2011 is on track for the highest S&P 500 corporate profits in history.
- Six months ago, the earnings estimates for the S&P 500 companies were just $96 per share. Now that's up nicely to $99.20.
- Also six months ago, the 2012 earnings estimates for these same S&P 500 firms stood at $106.71. Now that’s up nearly 6% to $112.50.
So not only do we have attractive year over year earnings growth, but more importantly, we have earnings estimates moving higher, which means that companies are exceeding expectations. Those higher estimates are a strong leading indicator of where stocks are headed in the future.
2. Valuation. Thanks to the strong earnings noted above, stocks are trading at very attractive levels. That can clearly be seen by two common valuation metrics:
- Price to Earnings Ratio (P/E): The earnings estimates for the S&P 500 this year currently stand at $99.20. Dividing that into the current level of the S&P shows that stocks are only trading at PE of 12.8. That is a substantial discount compared to the average historical PE range of 14-15.
- Earnings Yield (E/P): Now consider the earnings yield of stocks, which is dividing that same $99.20 in earnings by the current S&P price level. That comes out to 7.8%, which is a very attractive return compared to the meager 3% yield on the 10-year Treasury.
Note that the average earnings yeld minus inflation over the last 50 years is just 2.4%. When the stock market is above that mark, stocks are considered attractive. Below that mark, they are pricey.
Core inflation at only 1.5% means that stocks are trading at an earnings yield minus inflation of 6.3% -- well above the attractive 2.4% level. Even if you went with the loftier 3.4% non-core inflation figure, you’d still want to back up the truck on stocks, given their attractive valuation versus inflation or any form of interest-bearing investments.
3. QE2 = End of the Bond Rally. The 30-year bond rally was about to end in the fall of 2010. Then it got a reprieve from Fed chairman Bernanke in the form of a second round of quantitative easing (QE2). This $600 billion artificial buying of bonds has kept rates at historically low levels with really only one direction to go: Up.
Starting in July, the Fed will cease its massive $600 billion bond-buying operation. With that, bond prices will trade on a more natural supply/demand basis. Most signs say that should result in higher rates for bonds.
Here is the chain reaction that will take place from there: High bond rates = lower bond prices = losses for bond investors = more money flowing out of bond funds = more money flowing into stock funds to seek a better rate of return = higher stock valuations as more dollars enter the market.
4. Individual Investors Ready to Get Back In. Survey after survey show that the average individual investor is still scared by the stock market. This makes sense when you consider how the massive losses from 2008 and 2009 are still fresh in their minds. Then toss in all the volatility the past couple years, including this summer, and you can understand why many investors have been saying “no thanks” to stocks for a while. But given human nature, they won’t stay away for long.
When the market begins pushing back to the recent highs and beyond, the media will start to make a big deal about the stock market once again. The more this positive message gets out there, the more individual investors will feel they are missing out on all the profits. As they pile into stocks, it will fuel the rally higher -- which will pull even more investors from the sidelines back into the market.
How high can the market get? Given the valuation scenarios I shared above, we can easily make it to a Dow of 13,000 or an S&P 500 of 1,400 without being overstretched. And if the pendulum starts to swing away from fear and back to greed, it could go well above that level over the next 12-18 months.
What to Do Next?
On the surface, I know it sounds like I am saying to just buy any stock and you will profit from this rally. Certainly the rising tide usually lifts all boats -- but some boats do a lot better than others. First, you need to focus on companies exceeding earnings expectations each quarter, which leads to higher estimates from analysts. This in turn leads to higher investor interest and a higher share price.
Second, keep an eye on valuations. Yes, I noted earlier that the overall market was reasonably priced. However, each week that I go looking for new stocks, I am noticing that more and more are overpriced. So only select those stocks that are trading at discounts to peers.
Here are five such stocks that meet both of these important criteria for stocks likely to excel.
- Apple (NASDAQ:AAPL): Few large companies have such a long string of crushing numbers each earnings season. Nor does it trade at such a ridiculously low valuation (PE of 11 after you back at cash per share). The risk and reward scenario on this stock is unrivaled in my opinion, with upside to $500 without even being close to overvalued.
- Columbia Sportswear (NASDAQ:COLM) is on an earnings hot streak, including a 28% beat last quarter. Outlook for the firm is very good, especially because of its recent success in the shoe/boot category. Sold off nearly 20% from the highs. Looks ready to run.
- Cummins (NYSE:CMI): One top-tiered brokerage firm said it best: Investors simply don’t appreciate the powerful secular growth story at play with CMI. Its engines are in high demand and show no signs of stopping. This firm has a $150 price target on CMI, which is more than 50% higher than now. When investors shake the gloom of this summer, I have little doubt these shares will head in that direction in a hurry.
- Eaton (NYSE:ETN): This diversified industrial player is the stoic pick of this group. The management team has consistently produced impressive profit growth and dividend increases for shareholders. About 40% of its business is considered “late cycle”; thus profits should grow attractively as this economic expansion matures over the next couple years.
- Ryder Systems' (NYSE:R) truck leasing and logistics business is also considered a late cycle bloomer like ETN. Toss in an attractive valuation and 2% dividend (well above your bank account) and you see the appeal of these shares.