3 Reasons Why The Recent Rally Can Continue

Includes: HDV, IOO, OEF
by: Russ Koesterich, CFA

Call #1: The rally was justified – and stocks still look cheap

Domestic stocks have now jumped around 20% from the October low, while emerging markets and European equities have jumped by approximately 25%. This is a big move, but is it justified? I believe so, and here are three reasons why:

First, and most important, a large part of the late summer sell-off was precipitated by a growing belief that the United States and the global economy were about to enter another recession. While recent economic data is still soft, it has been largely better-than-expected, including Thursday’s third quarter gross domestic product report. The data confirms my view that the economy will continue to expand, albeit at a slow pace.

Second, stocks were very cheap at the lows, and even today continue to look inexpensive, particularly relative to bonds. Globally, stocks are still trading for 13x trailing earnings, with emerging markets at a multiple closer to 11x. These valuations are still well below the long-term averages, especially when you take into account the low inflation, low interest rate environment. In other words, there is still room for some modest multiple expansion for most equity markets.

Finally, it looks like a meltdown in Europe will be avoided, at least in the near term. Investors were rightly concerned over the crisis in Europe, but last Thursday’s plan addresses some of the issues, notably a larger haircut for investors in Greek debt and a start at recapitalizing the banks. As such, it will probably help avoid a crisis and removes a big source of near-term risk.

That said, I don’t believe the plan resolves all of Europe’s longer-term problems. This plan removes the near-term threat, but it is likely that the issue will return in 2012. For now, with the economy stabilizing, valuations still cheap, and Europe’s problems temporarily moved to the side, I think stocks can move higher, and I would remain overweight equities.

For investors looking for broad equity exposure, we would continue to favor the large- and mega-cap dividend payers (potential iShares solutions: OEF, IOO and HDV).

Call #2: Revert to neutral on REITS

I discussed underweighting this sector back in late July, believing that investors were stretching too far for income. As a result, these stocks looked too expensive relative to both financials and the broader market.

Since then, REITS have lost around 7%, underperforming the market by around 3%. As valuations have now come in significantly, I would remove the underweight and revert to a neutral stance on the REITS.

Disclosure: Author is long IOO.

REIT investments are subject to changes in economic conditions, credit risk and interest rate fluctuations. There is no guarantee that dividends will be paid.

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