It's Too Early To Go Fishing
With the Dow Industrials, Dow Transports, and Wilshire 5000 Index of all U.S. stocks reaching all-time highs in May, the majority money opinion is not in doubt. The question is whether investors' enthusiasm has exhausted much of the market's upside potential, positioning stocks for subpar long-term returns.
For perspective on such questions, Dow Theorists divide bull markets into three phases. In the first, confidence revives and stocks rebound close to fair value. In the second, often the longest, fair value adjusts as earnings and dividends improve. In the third, speculation is rampant and stocks advance on hopes and expectations.
William Hamilton, who popularized the three-phase idea, conceded that distinguishing phase two from phase three was not easy, making it harder to call a market top than a market bottom. As he wrote in 1926: "After a long bear market the discrepancy between the average price and what may be assumed as the line of values on real earnings, dividend yield and the value of money, is easily apparent. But after a long advance, many stocks are selling well within proved value. Any may have possibilities by no means discounted."
Because fair value can be tough to pin down, Hamilton told his readers to consider investor sentiment: "Experienced traders in Wall Street say that when the elevator boy and the shoeblack are asking for bull tips on the market it is time to sell and go fishing."
Today's sentiment readings are mixed. Investment newsletters are unusually optimistic, with bulls exceeding bears by the widest margin since January, according to Investors Intelligence. Yet polls of individual investors reveal a lack of enthusiasm for equities. And the Bank of America Merrill Lynch Sell Side Indicator, which tracks the average stock-allocation weighting of Wall Street strategists, shows equity exposure well below long-term norms.
Brisk dividend growth
While it's tough to draw a firm conclusion from today's sentiment indicators, we are clearly not seeing the type of widespread euphoria often present at market tops. Also, a case can be made that the stock market's fair value is still rising, especially considering the trend in dividends.
Among stocks in the S&P 500 Index, 424 pay dividends, above the norm of 391 since 1994. Some 216 stocks in the S&P 500 offer yields greater than 2%, above the norm of 192. For the broader S&P 1500, 479 stocks offer yields topping 2% — well above the norm of 425.
Among S&P 500 dividend payers, average year-to-year dividend growth was about 16% for the 12 months ended April, compared to a norm of 11% since 1994. For the S&P MidCap 400 and S&P SmallCap 600, average dividend growth is nearly double the long-term norm.
Of course, continued dividend growth will depend on profit growth, which has slowed. But the median company in the S&P 1500 delivered 5.3% growth in per-share profits in the most recent quarter. With growth in the economy and profits likely to accelerate — and yields on 10-year Treasury bonds at an 11-month low below 2.44% — U.S. stocks still compare favorably to other assets. Our buy lists have 93% to 98% in stocks.