Why Stocks Can Move Higher

Includes: DIA, EEM, QQQ, SPY, VWO
by: Russ Koesterich, CFA

Global equities rallied last week after a sharp pullback in U.S. long-term interest rates and better-than-expected second-quarter earnings. This raises the question: "Can equities still move higher?"

As I wrote in my latest weekly commentary, although gains may become more muted in the second half, I believe that global stocks can continue to advance for the next six to 12 months. Here are four reasons why:

  1. U.S. inflation is not a real threat, as evident in last week's import price and core producer price index figures. The reports confirm that inflation concerns are unlikely to force the Fed into a quick exit from monetary accommodation.
  2. Bond yields will remain volatile, but won't "melt up." In addition to tame inflation, there are a number of other factors keeping a lid on rates (such as foreign central bank buying). This means that the most likely rate scenario is for volatile, but sideways, movement. I believe the 10-year Treasury yield will hover around 2.5% for the foreseeable future. And in light of the growing interconnectedness of stocks and bonds, range-bound rates should allow for additional gains in stocks.
  3. Corporate balance sheets remain healthy.
  4. Stocks, particularly international ones, appear reasonably priced relative to their own historical valuations and to cash and bonds.

To be sure, there are certain scenarios that could derail the 2013 rally. These include a prolonged and substantial move over 3% in the 10-year yield, a flare-up of the European sovereign debt crisis, and rising tensions throughout the Middle East. But assuming these events don't occur, the points I cite above should support stocks.

So what does this mean for investors? I continue to believe that investors should consider overweighting equities in their portfolios over the long term. In addition, investors underweight international equities may want to increase their exposure to non-U.S. stocks (including emerging market equities), which look particularly cheap and are already discounting a lot of bad news.

On a price-to-book basis, international developed markets are trading at around a 35% discount to the U.S. market, while emerging markets are trading at an astounding discount of more than 40%. On that note, although last week is a brief snapshot, it's worth pointing out that while U.S. stocks had a strong week, international markets (including emerging ones) actually outperformed.

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