The least loved stock market rally in recent memory is now making history. The Dow Jones Industrial Average, on the morning of March 5, 2013, reached its highest level ever (the more broad-based S&P 500 Index remains within a hair of its prior high), surpassing the 2007 peak and erasing the losses of the financial crisis. It hasn’t always been easy and investors have at times (think spring 2010 and summer 2011) required a stiff spine, but we’ve actually made good timing. As Bloomberg reported, “It took the Dow less than 65 months to rise above its previous high set on October 9, 2007, more than a year faster than the recovery from the Internet bubble.”
Still, investors appear to continue to fight the rally every inch of the way. Equity mutual funds infamously experienced more than $100 billion in net outflows in 2012, and even the early-2013 rush into equity funds has slowed in recent weeks. To the naysayer the stock market is too sanguine about the risks that lurk behind every corner. I’m not blind to the challenges that we face, there are plenty of things to worry about. But we don’t live in special times, there are always plenty of things to worry about. Markets tend to climb walls of worry.
Investors still appear excessively cautious given the actual risks they face today. As I said at the beginning of the year, I believe that central banks’ extraordinarily accommodative stance makes the outlook more certain than it has been in the recent past, not less so. I maintain that argument even with equities up some 8-9% since New Year’s Day. Despite equities reaching record highs, there are still very compelling reasons for stocks going forward.
Absolute valuations: The Dow is trading at 13.7 times its trailing 12-month earnings, 20% below its price-to-earnings ratio at the 2007 peak and 15% below its 20-year average. For the S&P 500, the valuations appear even more compelling. The index is trading at 15.0 times its trailing 12-month earnings, 50% below its price-to-earnings ratio at the 2007 peak and 24% below its 20-year average. This is not just a U.S. story. The MSCI World Index is also trading at more than 20% below its 20-year average.
Relative valuations: Stocks are as cheap to bonds as they have been in decades. The spreads between the yield on the 10-year U.S. Treasury and the earnings yields of the Dow, the S&P 500, and the MSCI Global Index are as wide as they have been since the late 1970’s. Investors have a significantly higher potential claim on corporate earnings than they will receive in income generated in traditional fixed income securities.
Accommodative Policy: The old adage is “Don’t fight the Fed,” not “Go with the Fed,” because, well, investors have a tendency to fight the Fed. But at what cost? By now, the Fed has already destroyed the coupons of cash and high quality bonds. This era of financial repression can go on indefinitely. Fed Chairman Ben Bernanke, for better or for worse, said as much at his latest Humphrey-Hawkins testimony. Investors will never reach their goals earning negative real yields. Go with the Fed. The zero interest policy continues to incentivize investors to buy stocks.
The case for U.S. equities can extend to modest inflation, limited pent-up consumer or business demand, generally favorable demographics and even fiscal policy, which has potentially stabilized debt to GDP over the next decade, among other things.
To investors still on the sidelines watching as equity indices hit new milestones, I say it is not too late to get involved. A new high is not in itself any kind of danger sign. Stock market averages are not mean-reverting, they are a mirror on a growing economy for the U.S. and the world. If you believe the U.S. is a growing concern you should expect markets to trend upward over long periods. It’s when the valuation gets ahead of itself and there are few bricks left in the wall of worry for equities to climb, that I begin to worry.