A Few Reasons to Continue Equity Exposure

 |  Includes: DIA, IVV, SPY
by: Caleb Sevian

There is an old market adage that says “the market will make as big a fool of as many people as possible as many times as possible”. Although the market has been on a tear, money flows have actually been out of index funds for the past five weeks in a row, indicating that investors are fearsome that the rally of the last six weeks will end badly.

Investors point to a slowing economy, inflation fears, housing jitters, energy prices, and currency worries; nevertheless, the market keeps pushing higher. The latest hurdle the market seems to have cleared had to do with Q1 earnings. According to Thomson Financial, 81% of the S&P500 reported earnings for Q1, averaging 8.1% - a far cry from the 3.3% estimate analyst had predicted before the quarter. In all likelihood, when all is said and done, Q1 will probably end up north of 9%, still well above trend earnings growth.

When we look out for the remainder of the year Thomson’s has the following estimates: Q2 est. 3.9%, Q3 est. 5.9%, and Q4 est. 11.8%. Keep in mind analysts tend to lower their numbers slightly as we move closer to quarter end, based on preannouncements, so these numbers will probably be revised lower. The trend, however, seems to be clear; analyst expectations are that the first couple quarters of this year will be slow with earnings accelerating later in the year. If this is truly the case, given the market tendency to discount six to nine months in advance, a substantial sell off this summer seems questionable.

There are further signs pointing to prolonged market strength in the coming months. First of all, my own contrarian view is that nervous investors paying homage to the adage “sell in May and go away” are driving large numbers of people from the markets. This is leading to a build up of cash on the sidelines. Any substantial sell off will likely be met with an influx of buying that will give support to the markets. One of the other big factors contributing to market strength has been the continued cash stock piles amassed by corporate America. Public companies are putting this money to work buying their own stock back; private equity firms are putting it to work buying public companies; these two factors are contributing to a supply / demand imbalance in the stock market, manifesting itself as too little stock, too much money. This is making stock a scarce commodity. If it continues, valuations will be driven higher purely on demand.

That brings us to valuations: based on simple P/E’s, the market is relatively inexpensive. The current S&P 500 P/E is about 17.3. Commentators commonly point to historic averages; since 1920 the average P/E has been 14.5, but a lot has happened since 1920, so perhaps we should look at a more recent period. Since 1960 the average P/E has been 17.5. Let’s look at the last ten years: since 1996 the historic average has been 23.6. By recent standards the market is inexpensive. The other interesting conclusion that can be drawn from this the continued trend of multiple expansion.

Michael Ashbaugh from Marketwatch (U.S. markets may still have significant upside - MarketWatch) wrote an interesting piece last week about the total return of the markets in the recent past. In his piece, he calculates the total return of the S&P500 to be -3.7% over the last seven years. According to my calculations, the average earnings growth over the past seven year has been over 16%, double the average historical earning growth of the S&P500. If the S&P500 would have had a reasonable rate of return given its earnings growth of say 10% a year return over that time, it would be at over 2900 right now. It should also be noted that the S&P500 and the Dow Jones Industrial average have now both broken above their all time highs set seven year ago, a bullish sign. Both the transports and the industrials are trending higher, another bullish sign.

I would never say the market is not going to have some profit taking at some point soon; we have had a good run and there are always people looking to take money off the table when they have had a good run. What I am trying to say is that there are real reasons to be bullish based on the trends in corporate earnings growth, economic strength, valuations and expected returns models.