What Not To Believe


With year-end approaching, you are likely to hear a lot of conflicting opinions on the stock market's 2014 prospects. While knowing what to believe can be tough, sometimes it helps to know what is clearly wrong. Here's our take:

Stocks are not cheap. Just because the Dow Industrials are still trading below the inflation-adjusted peak of January 2000 does not mean the market is cheap. The big growth stocks in the Dow Industrials and S&P 500 were very expensive in 2000. Now big stocks trade at a slight discount to the broad market, which is unusually expensive. The median stock in the broad S&P 1500 Index trades at 20 times trailing earnings, above the norm of 18 since 1994.

Stocks are not in bubble territory. At less than 19 times expected current-year earnings, the median S&P 1500 stock trades at a 13% premium to 10-year norms. Valuations have reached much higher levels at previous market peaks. Also, relative to today's bond yields, P/E ratios are unusually low. One caveat: Price/sales ratios are at 20-year highs, so stocks could be vulnerable if profit margins revert to historical norms.

Profits and sales are not stagnant. While growth rates have slowed since 2010 and 2011, the median S&P 1500 company reported 8.0% year-to-year growth in per-share profits in its most recent quarter. That means one-half of S&P 1500 members delivered growth of at least 8.0%, only slightly below the norm of 9.1% since 1994. The median S&P 1500 company delivered 5.4% sales growth, versus the long-term norm of 6.1%. Considering today's unusually low inflation, real growth rates look even better.

The stock market has not run out of potential catalysts. Some bears argue that the good news has already played out because the Federal Reserve policy is likely to become less stimulative and investors already anticipate an improving world economy in 2014. But takeover activity has yet to heat up despite cheap financing and strong corporate balance sheets, even though recent acquirers have seen their stocks outperform. A surge in takeovers would not be surprising. Nor would continued strength in dividend growth and share buybacks, as companies are still paying out an unusually low proportion of earnings in dividends.


We still think the odds favor the bulls. The primary trend is squarely in the bullish camp under the Dow Theory, and we are keeping 95% to 96% of our buy lists in stocks.

The median company in the S&P 1500 delivered 8.0% growth in per-share profits in its most recent quarter, lower than about 70% of the monthly observations since 1994 but not far below the 19-year norm of 9.1%.


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