Lexington, KY - It was just about three years ago when the market bottomed amid the depths of the Great Recession. At that time, there was little to be positive about. Today with equities 111 percent higher, some investors believe we will soon revisit 2008 and panic will ensue.
While there is plenty to fear, such as a European bankruptcy or spiking oil prices, there is also plenty to be positive about — including the pickup in jobs, accommodative central banks, Greece’s successful debt restructuring and more.
With the improving economic data, there is little chance of a recession this year. Economists now expect that our economy will grow 2.5 percent for all of 2012.
Perhaps the biggest fear that could push the economy and stocks lower is a European credit crisis, with problems in Spain or Italy acting as the catalyst. Spain being the bigger concern due to the Bank of Spain’s exposure to the nation’s bursting real estate bubble. We think the Troika (the ECB, IMF and EU) will not let Spain traverse the same path as Greece. The political will of these Eurocrats is great, and they will do everything in their power to quickly save Spain, if it comes to that.
Focusing on market valuation and fundamentals presents an appealing story for stocks. Comparing the S&P 500’s current price to the expected earnings over the next 12 months gives us a forward P/E ratio of 13.8. This value is less than the long-term average since 1871 of 15.5. Assuming earnings estimates are relatively accurate (and barring the unlikely chance of a recession, they should be), one would expect the stock market to appreciate, pushing the P/E ratio closer to its long-term value.
Another way to analyze earnings is to compare the earnings yield (earnings divided by price or the inverse of the P/E ratio) to bond interest rates. Again, using forward earnings, we get an earnings yield of 7.2 percent. In other words, 7.2 percent of each dollar invested makes its way to the bottom line. The interest rate on the 10-year Treasury bond is 2.2 percent, which means there is a 5 percent risk premium embedded in equities. From a historical point of view, this is higher than normal, meaning stocks are more attractive than bonds.
The economic data is making nice strides as well. The jobs market is healing as the unemployment rate has dropped to 8.2 percent. While the latest monthly report showed fewer jobs being added than expected, the total jobs added for the year is solid. Furthermore, the manufacturing and service sectors, as measured by the ISM, have consistently been in expansion mode. These indicators suggest that an economic slowdown is not in the near future.
Another reason for optimism is that investors have remained skeptical of equities despite the strong rally over the past six months. This can be seen in the flow of funds report. According to Investment Company Institute (ICI), investors have withdrawn $15.6 billion from equity funds and have added $93 billion to bond funds since the beginning of the year. This is bullish because if the market keeps rallying, investors will get nervous about missing out on future gains. They will then pour their money into equities, pushing stock prices higher.
It seems, based on fundamentals and sentiment, that stocks should head higher throughout the year. One must keep in mind that it will not be in a straight line though; it will be a process filled with corrections and rallies. If past is any guide, a good first quarter often leads to a good year. Looking at all years since 1926 when the S&P returned more than 10 percent the first quarter (it was 12.5 percent in 2012), the ensuing results have been quite strong. The average return for the final three quarters of the year was 7.8 percent, with positive results eight of the nine times. Unless there is an extreme event (e.g., Spain defaulting) or the underlying economic fundamentals change, we believe the stock uptrend in place should continue.
The bond market saw long-term yields drift higher in the first quarter as the data indicated our economy would avoid a recession. As a result, the yield curve steepened a bit. We would expect the long end of the curve to slowly drift higher over the next couple of years as the economy becomes more sustainable. Under this scenario, bonds with shorter maturities and ones tied to economic growth should perform well.
Studying the interest rate spread of municipal bonds and Treasuries shows that municipals are trading at a discount compared to their historical levels. One reason this asset class is attractive is because its revenues have rebounded. Also, if tax rates go up, the demand for municipals will soar. Finally, with interest rates on municipals relatively high, they have become appealing to those who are not in the upper tax brackets. These demand factors should give municipals an edge over Treasuries.
To sum up, we are relatively positive on the markets; however, there will be bumps and bruises along the way. Similar to last year, there will probably be a scare out of Europe, but it will likely be dealt with rather quickly compared to 2011’s European drama.
Andrew Stout, CFA, CFP is senior investment officer, MCF Advisors, and can be reached at astout@mcfadvisors.com.