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Where Is Our Happy Ending?

When watching a movie, particularly a romantic comedy, I know even early on when there will be a happy ending. That's why Jennifer Aniston's The Break-up is so disappointing. When viewing the economy, the markets, and even our political future, our clients are not feeling the happy ending.

America is a very optimistic country. We are willing to try all kinds of things, faithfully hoping those things will turn out. Going to the moon in ten years was a ludicrous goal in 1961. We revel in these long shots such as Rudy and the Cubs, successful or not. Is betting on the US economy and US markets a long shot? The average investor thinks this is a long shot. Hardly--but stick with me while we work it out.

Many of our futures are tied to the markets. While not a binomial outcome, a win or die option set, success here makes a big difference to our lives. It could be the difference between living in Gangnam Style or being a poser. Other relevant factors beside market success are: time horizon, savings rate, taxes and spending rate. Today, we will focus on the markets and the likelihood of success.

First, let's define success. I will define it as a market making at least as much money as it historically has. Since most investors start with the idea of asset allocation, and that being primarily between stocks and bonds, I will deal with these two markets. Since 1975, investment grade bonds have returned inflation plus 4%, while the S&P 500 has returned inflation plus 7%. Inflation is currently running about 2% and is likely headed higher to, say, 2.5%. The target, therefore, for bonds is 6.5%, and for stocks it's 9.5%. The time frame should be reasonable enough for current concerns to resolve and for new problems to arise, or between 3 and 5 years.

Bonds have virtually no chance of making 6.5% per year over the next three or five years. With yields well below 2%, the only way to make 6.5% is for yields to decline and for bond prices to rise. How much would rates have to decline? To achieve 6.5% over three years, rates would have to drop 3% to negative 1.5%. For bonds to achieve 6.5% over the next five years rates would have to decline by 5% to negative 3.5%. This is truly not possible. So from the bond buyers' perspective the next several years will be disappointing at best. At worst this is a bond bubble. Just the facts, Ma'am.

The stock market's future is less math and more guess work. Stocks are selling at an average Price to Earnings ratio of 14. Earnings on the S&P 500 are about $100 and therefore the S&P 500 is currently about 1,400. Earnings growth has slowed in the third quarter to zero. Can earnings grow at 7.5% (9.5% minus 2.0% of dividends) for the next three or five years? Maybe, but it isn't very likely. I would put a probability of 20% on earnings growing this fast. Can the P/E's rise to 17 times to achieve the 9.5% return? This is dependent on market psychology and hard to predict, but I would give that a 10% chance. So there is a 30% chance of stocks achieving their historic returns if one of these two events occurs. However, if P/E's rise a little and earnings grow a little, then this goal is far more likely to be reached. For instance, if earnings grow at only 5% but P/E's rise to 15 the goal is achieved. The probability that stocks will earn a higher than historic return over the next three to five years is better than 50/50.

With no chance of success for bond investors and a better than 50% chance of success for stock investors, I think the choice is clear. For investors who can look beyond our current problems, there is a bright future. While fiscal problems in Greece and Washington dominate our current investment thoughts, both Europe's and ours will eventually be solved. And by that time, odds are stocks will be higher and bonds will be lower.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: (c) Regions Bank, Member FDIC. The foregoing represents the opinions of the author, Brian Sullivan, and not necessarily those of Regions Bank or Regions Investment Management, Inc. (RIM). RIM provides commentary to clients of Regions Bank, an affiliated company wholly owned by Regions Financial Corporation. The information contained in this report is based on sources believed to be reliable but is not guaranteed as to accuracy and does not purport to be a complete analysis of the security, company or industry involved. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This report is designed to provide commentary on market strategy and the opinions expressed reflect the judgment of the author as of the date of publication and are subject to change without notice. RIM assumes no responsibility or liability for any loss that may directly or indirectly result from the use of such information by you or any other person. Investments discussed in this report are not FDIC-insured, not deposits of Regions Bank or its affiliates, not guaranteed by Regions Bank or its affiliates, not insured by any government agency, and may go down in value. Investment advisory services are offered through RIM, a Registered Investment Adviser. RIM is wholly owned by RFC Financial Services Holding LLC, which in turn, is a wholly owned subsidiary of Regions Financial Corporation.