Five reasons to Like Stocks

05/19/2017 2:50 am EST

Focus: STRATEGIES

John Boyd

Editor, Fidelity Monitor & Insight

The list of worries for stocks is long indeed: the North Korean nuclear threat, Marine Le Pen in France, weak first-quarter GDP, concerns of overvaluation, fear of higher interest rates, little or no progress on President Trump’s pro-business agenda, and on it goes, asserts John Boyd, editor of Fidelity Monitor & Insight.

Yet the stock market has continued to climb this “wall of worry” in classic bull market fashion. And there are several reasons why we believe this old bull has more room to run.

Interest Rates Remain Historically Low

Inflation is muted and the Fed is likely to stay cautious. While we could see two more 25 basis point hikes later this year, that would only bring short-term rates (Fed Funds rate) up to 1.25%-1.50% — well below their 4-5% range prior to the financial crisis.

Our long-term rates, while also historically low, are still among the highest in the developed world, attracting strong foreign demand. Combine that with a lack of inflationary pressures, and long-term rates should not spike higher, either.

Earnings Are Strong

With about 30% of the S&P 500 reporting, first quarter earnings came in at 1% above estimates, the highest in five years according to Savita Subramanian of Bank of America Merrill Lynch (and they have continued to surprise to the upside).

Moreover, managements’ positive tone on earnings calls has been notable with the word “better” versus “weak” or “weaker” at levels not seen since 2010. Earnings per share (helped by buybacks) jumped 21% in last year’s fourth quarter and are on track for similar gains in this year’s first quarter.

Few “Believe” In This Market Advance

In a recent survey, 83% of fund managers thought domestic stocks were too expensive and individual investors are mostly dour as well. In the Association

Of Individual Investors weekly sentiment poll of 4/20, bullishness] was 25.7%, a new post-election low and the 13th time in the past 14 weeks it has been below its long-term average of 38.4%. As I have noted many times in the past, bull markets don’t end when everyone is bearish!

Stocks Are Undervalued

I bet that got your attention! The overwhelming consensus is that stocks are overvalued. The current P/E of the S&P 500 is around 21. That compares to an average of 19.2 over the past 25 years. While not excessively overvalued, stocks don’t look cheap, either.

However, if we compare stocks to bonds, we get a different picture altogether. To compare stocks and bonds, we look at the yield on the 10-year Treasury versus the earnings yield on the S&P 500.

The earnings yield is just the inverse of the P/E ratio, or the earnings of the S&P 500\ divided by its price. Based on estimated first quarter earnings, and the value of the S&P 500 as of March 31, the earnings yield is 4.71%, versus the 10-year’s current yield of just 2.29%.

The ratio of that 10-year yield versus the earnings yield of 0.49 compares to an average since 1973 of 1.09. No less a sage than Warren Buffett recently remarked: “measured against interest rates, stocks are on the cheap side compared to historic valuations.”

Discounting Of Tax Reform

After Trump’s failure on health care and other stumbles, expectations of a boost to the economy from his tax reform proposal have largely been wrung from the market. Should he succeed, and I think he will get something done, that should provide further fuel for the market.

And there are other factors as well. The IMF just revised its forecast of global growth this year to 3.5%, up from 3.1% in 2016, which will benefit U.S. exporters. The positive effects of stable and low oil prices are still rippling around the world.

Lastly, for the technically inclined, on April 12, the S&P 500 fell below its 50-day moving average after trading for over 100 days above it. This has happened 17 times previously since 1935. 88% of the time (15 out of 17), the S&P 500 was higher over the next 3 months by an average of 4.8%.

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