Rising Profits + Falling Bond Yields = Higher Stock Prices
Broad U.S. indexes weighted by stock-market capitalization, including the S&P 500 Index of large stocks and Wilshire 5000 Index of nearly all stocks, have rallied to all-time highs. While the Dow Industrials and Dow Transports have yet to confirm the new highs, our three-part advice is unchanged:
• Watch the averages. With closes above the July all-time highs of 17,138.20 in the Industrials and 8,468.54 in the Transports, the primary trend would be reconfirmed as bullish under the Dow Theory. Without new highs in both averages, a breakdown below the respective August lows of 16,368.27 and 7,992.08 would represent a bear-market signal.
• Look for buying and selling opportunities one stock at a time. Don't put your investments on hold as you wait for new highs from the averages. Whether you are bearish or bullish, always strive to have the best possible stocks in your portfolio.
• Maintain nearly fully invested portfolios. Our Buy List and Focus List have 97.6% in stocks, while our Long-Term Buy List has 94.8%. While that may seem high considering the lack of a bull-market confirmation, remember that the Dow Theory is already in the bullish camp.
Why are U.S. stocks trading near all-time highs despite turmoil in the Middle East and Ukraine, sluggish growth in Europe and China, and widespread expectations that the Federal Reserve will begin raising U.S. short-term interest rates in 2015?
There are as many answers to that question as there are stock-market strategists. But Occam's razor — the scientific principle that the simplest of competing theories should be preferred to more complex explanations — argues for a two-part explanation: Earnings are up, and bond yields are down.
One-half of S&P 500 companies delivered at least 9% year-to-year growth in per-share profits in their most recent quarter, only slightly below 20-year norms. Consensus per-share-profit estimates for the S&P 500 Index call for growth of 8.7% for 2014 and 12.0% for 2015 — slightly better than what was projected on April 1, according to Thomson Reuters.
Meanwhile, the yield on 10-year Treasury bonds has dropped below 2.4%, down from 2.8% on April 1, helped by modest inflation (the Fed's preferred inflation gauge has undershot the Fed's 2% target for more than two years) and falling yields overseas (German 10-year yields recently hit an all-time low near 0.9%).
The median S&P 500 stock has a trailing P/E ratio of 19.3, equating to an earnings yield (E/P ratio) of 5.2%. That is 2.8% above the yield on 10-year Treasurys, compared to an average spread of 1.2% over the last 20 years.
If 10-year yields jump to 3.9%, the spread would return to the 20-year norm. If 10-year yields remain at 2.4%, the median P/E would need to jump to nearly 28 to return the spread to the 20-year norm.
Could the median P/E jump to 28? It seems unlikely. But could investors come to see P/Es of 21 or 22 as reasonable if low bond yields persist? Stranger things have happened.