Stocks Out Of The Bargain Bin
After the steepest nine-week gain since the 1930s, the major averages have moved sideways since early May. Increasingly, market progress will require concrete signs of recovery in the global economy. Action in the bond market will also be crucial, as surging Treasury-bond yields are undermining the argument that stocks are cheap. For now, as a partial hedge, we’re keeping about 31% to 33% of our equity portfolios in Vanguard Short-Term Investment-Grade ($10.11; VFSTX).
A lot can change with a 30% rally in the Dow Industrials. The percentage of bullish newsletters now exceeds the percentage of bearish newsletters by 12.5% — a sharp contrast to early March, when bears outnumbered bulls by more than 20%. Even consumers are feeling more upbeat, as reflected by a move to eight-month highs in the Conference Board’s consumer-confidence index.
Among institutional investors, fears of a depression have given way to fears of inflation, reflecting massive government stimulus efforts. With investors seeking inflation hedges and speculating on renewed growth in China, money has poured into gold, oil, and other commodities. The U.S. dollar and prices of U.S. Treasury bonds have dropped sharply since March, partly because investors are seeking higher returns in non-dollar assets.
Because of the rebound in investor confidence — and continuing weakness in corporate earnings — stock valuations have climbed. Total U.S. corporate earnings have declined for seven consecutive quarters, and consensus estimates project two more down quarters before a rebound. Despite better-than-expected earnings for the March quarter, estimates for S&P 500 Index profits in 2009 and 2010 continue to slump.
Excluding stocks with price/earnings ratios below 0 or above 75, the median stock in the S&P 1500 Index trades at nearly 15 times expected current-year earnings, up from about 11 in March but below the five-year norm of 17.
Based on the relationship between the S&P 500 Index’s trailing P/E ratio and yields on investment-grade corporate bonds, stocks remain cheap versus historical norms. But yields on corporate bonds will rise if yields on Treasury bonds continue to surge.
A move higher is possible if economic indicators provide support, but we expect a meaningful pullback in coming months. If the March lows in the Industrials or Transports hold on such a pullback, the stage would be set for a bull-market signal. If the March lows are violated, the bear market will be reconfirmed.