Cyclical Strength Would Be Bullish


U.S. stocks are expensive — unless you expect continued solid growth in corporate profits and continued below-normal bond yields.

As shown on the right, the median trailing price/earnings ratio for stocks in the S&P 500 Index is 20.6. That is 13% higher than the norm of 18.2 since 1994 — and higher than 87% of month-end observations since 1994.

But the median S&P 500 company delivered 9.6% year-to-year growth in per-share earnings in its most recent quarter, exceeding the long-term norm of 9.2% for the first time since February 2015. Median sales growth was 7.1%, above the norm of 5.9%.

Assuming stocks move sideways and earnings growth of 8% to 12% continues — in line with consensus estimates for the S&P 500 Index — the median S&P 500 stock would trade at a P/E below the long-term norm within 18 months. 

Relative to bond yields, the median S&P 500 stock already trades at a substantial discount. In fact, the median S&P 500 earnings yield (E/P ratio) exceeds the yield on 10-year Treasury bonds by 2.6%, versus a spread of 1.5% for the long-term norm. All else equal, Treasury yields would need to climb to nearly 3.4%, up from 2.3% today, for the spread to return to the norm.

Many had assumed bond yields would rise once the global economy strengthened and the Federal Reserve began to lift short-term rates. But Europe, the U.K, and Japan have delivered better-than-expected economic growth this year, and U.S. annualized growth is expected to accelerate above 2.5% for the remainder of 2017. Yet bond yields have dropped since March, partly on mild inflation data.

The big question

Have bond yields declined because of favorable inflation news, or because the outlook for the economy (and corporate profits) is poised to downshift?

That's a tough question to answer in real time, but strength in the Dow Transports and other cyclical stocks would suggest growth in the economy and corporate profits is likely to continue.

A rally above the March 1 all-time highs of 21,115.55 in the Dow Industrials and 9,593.95 in the Dow Transports would reconfirm the bullish primary trend under the Dow Theory. If one or both averages fails to close at new highs, a breakdown below the lows reached since March 1 would be discouraging.

For now, we are maintaining a mostly invested posture, with 92% to 95% of our buy lists in stocks. Among top picks for new buying, ON Semiconductor ($16; ON) and Royal Caribbean Cruises ($108; RCL) offer timely picks.

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