Don't Sell This Market Short


With the S&P 500 Index up 177% from the low reached in March 2009, the idea that decent values are available in the stock market strikes many as preposterous. How much upside potential can stocks have when so many are near all-time highs?

The short answer: plenty, depending on the course of corporate profits and interest rates.

The long answer: Share prices are not the only things at all-time highs. So are sales, profits, and dividends. And with interest rates still unusually low, the typical U.S. stock still looks cheap relative to bond yields. While we are concerned about signs of speculation in some richly valued groups, valuations alone are not reason enough to exit the market at this point.

Profit recovery

Trailing 12-month operating earnings for the S&P 500 Index have jumped nearly 150% since March 2009. Bears argue that corporate profits have merely rebounded off a recession low, that near-term earnings growth is nowhere near strong enough to justify today's valuations, and that a return to normalcy in interest rates could quickly erase the relative appeal of stocks versus bonds.

All three arguments hold some truth. But year-to-year earnings growth for the typical S&P 500 company is only modestly below 20-year norms. All else equal, corporate bond yields would need to rise by more than a full percentage point for the spread between bond yields and median earnings yields (earnings/price ratios) to return to 20-year norms.

Even without taking into account today's low interest rates, large-company stocks appear somewhat expensive but not outrageously valued. The number of stocks with trailing P/E ratios below 12 is unusually low. But 31% of S&P 500 stocks have trailing P/Es below 16, versus the norm of 38% since 1994. Some 41% have trailing P/Es below 18, versus the norm of 48%.

Small and midcap stocks are considerably more expensive than the big stocks in the S&P 500, but we are still finding opportunities among stocks of all sizes.

Caveats and conclusion

Our buy lists have 94% to 98% in stocks. Our nearly fully invested posture hinges importantly on the business outlook, as we don't think stocks are cheap enough to withstand a stall in profits. So, we'll be watching the averages for indications that the majority money opinion is anticipating harder times.

A close above 16,576.66 in the Dow Industrials would reconfirm the bullish primary trend. Without new highs in the Industrials, a breakdown below the Feb. 3 lows of 15,372.80 in the Industrials and 7,053.75 in the Dow Transports would represent a bear-market signal — and a reason to lock up some profits.

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