Why the Stock Market Could Continue to Rise
On October 11, 2007, the Dow Jones Industrial Average hit an intra-day all-time high of 14,198.10. After five and a half years the Dow now sits above 14,000 and is within a couple of percent from breaking through this ceiling.[i] Because of its torrid pace over the past 17 months, many investors are starting to point to indicators that predict that the stock markets may be nearing a peak. First, corporate insiders have become net sellers of stocks. According to the Vickers Weekly Insider Report, for the week ended February 1, 2013, corporate insiders of companies listed on the NYSE sold 9.20 shares for every share that they bought.[ii] Second, the amount of margin debt – the money borrowed to buy securities on the NYSE – is at a 5-year high. The last time it reached this high was in February 2008. Finally, money is starting to flow into equity-focused investment vehicles for the first time since 2007. During this time period, fixed-income investment vehicles saw record inflows. Yet, there are reasons to believe that the stock market could continue to climb higher.
Historical Stock Market Data
On February 13, 2012, Barron’s released a cover story entitled “Enter the Bull” on Professor Jeremy Siegel’s prediction that the Dow would likely hit 15,000 by the end of 2013 and could even break through 17,000, a 34 percent gain from the level at which the Dow was at on that date. Siegel, who wrote the best-selling book Stocks for the Long Run, based his analysis on past stock market cycles and the current market’s valuation. Siegel later wrote: “…when stock returns for the preceding five years fall in the bottom 25% of all five-year returns, as did the returns from 2007 through 2011, the annualized return on stocks in the following two-year period is 20%—more than double the market’s long-term return of 9.9% annualized. Moreover, the market achieves annual gains of 10% or more about 70% of the time.”[iii] Although the current Price-to-Earnings ratio of approximately 17 is close to the S&P 500’s average P/E since 1935, the average P/E of the S&P 500 is 23.6 when the yield on the 10-year Treasury bond is 6.7 or less (the yield is 2.04 percent on February 14, 2013).[iv]
As demonstrated by the above graph, the S&P 500 is not overvalued relative to its earnings compared to prior periods. In fact the earnings multiple in 2000 was double the current multiple. This means that stocks still could rise and not be overvalued in comparison. The average bull market – defined as a market that has risen at least 20 percent – has generated a gain of 160 percent and lasted 56 months. The largest, from 1990 to 2000, lasted 113 months and increased 417 percent. The current bull market has risen 122 percent and has lasted 47 months.[vi]
For the week ended February 14, 2013, the Federal Reserve’s balance sheet crossed the $3 trillion mark for the first time.[vii] This was up from approximately $800 billion during the summer of 2008. Of the $3.017 trillion, $1.723 trillion (57 percent) was held in the form of U.S. Treasuries and $978 billion (32 percent) was held in the form of Mortgage Backed Securities (MBS). The rest consisted of primarily Federal agency debt securities (Fannie Mae and Freddie Mac), loans, and cash value agreements.
From the above diagram from November 2012, it is readily apparent that the Federal Reserve has drastically increased its assets over the past 4 years. By purchasing Treasuries and MBS, the Fed hoped that these actions would drive interest rates down, and therefore increase consumer and investment spending. While interest rates have declined to historically low levels, the Fed has not been satisfied with the pace of economic growth. In September the Fed announced QE3 which consists of monthly purchases of $45 billion of U.S. Treasuries and $40 billion of mortgages. If kept in its current format, these $85 billion monthly purchases will push the Fed’s balance sheet to close to $4 trillion by the end of 2013. How could this affect the stock market? Each weekday the Federal Reserve buys approximately $4 billion of long-term Treasury bonds and mortgages. The Fed buys these securities from dealers (i.e. the major investment banks) by giving the seller a credit on their Federal Reserve statement. By simply changing a number in a spreadsheet, the Fed can create $4 billion in new money. The dealer that sells the bonds to the Fed can then keep the money at its account at the Fed or withdraw the money. With this money the dealer can buy other bonds in the open market. That purchaser then can buy any asset he or she likes with the proceeds. This includes the ability to buy stocks. While it is unknown how much of the newly created money is ending up buying stocks, it is almost certain that some portion of this money is being used for this purpose. By increasing the amount of money on a daily basis, the Fed is indirectly helping push up the amount of stock purchases. This “Bernanke Put” supports the Fed’s desire to create the wealth effect – people will feel wealthier since they see the value of their retirement accounts rise and as a result they decide to spend more money.[ix] While there are some grumblings from Fed presidents about curtailing QE3 at some point in late 2013, this might not occur until the Fed’s balance sheet is close to $4 trillion.
For the companies in the S&P 500, analysts see profits rising almost 11 percent to over $113 per share for the year 2013.[x] For earnings for the 4th quarter of 2012, approximately two-thirds of companies have beaten earnings estimates. For earnings for the 3rd quarter of 2012, approximately three-fourths of companies beat estimates. Corporations set guidance and then analysts use this guidance to project estimates of future earnings. For the past five quarters there have been more corporations issuing negative guidance than positive guidance. Yet, in each subsequent quarter, well over 50 percent of companies beat the average expectation. Corporate executives recognize that they can underpromise in order to make it easier to beat expectations. According to Bespoke Investment Group, there has been an average gain of 0.8 percent on the day of each company’s earnings report for the fourth quarter which has been the best one-day average gain in eight quarters.
As the above chart shows, earnings estimates for fiscal year 2013 have been lowered over the past year. As explained though, this is typically the case as companies have a tendency to guide lower than would be reasonably expected. However, earnings have continued to trend upward at a healthy clip. With many companies in the S&P 500 having cleaned up their balance sheets over the past 5 years, many cash-rich companies are better positioned to fend off any hiccups in the economy, and are set to strike through increase acquisitions if the economy remains on its upward trend.
The Great Rotation
Over the past 2 months, stocks inflows have outpaced bond inflows for the first time since 2007. With bond yields at near-historic lows, it would not be surprising if investors were investing into other assets that have not performed as well. Yet, this might not be the case. In the first week of February, assets in money market accounts fell by $4.14 billion.[xii]
As Gerard Minack, Head of Global Developed Markets at Morgan Stanley, pointed out, the outflow from equities over the past 5 years cannot explain the massive inflow into bonds during that same time period. However, there have also been large redemptions from money market accounts which could explain the huge move in bonds during this time period. As interest rates on money markets account are close to zero, investors shifted those assets into fixed-income securities that could provide a higher return. This reach for yield has been the driving force behind the continued outperformance of corporate and high yield bonds. As the yields in these sectors are now approaching record lows too, more money from money market funds could soon find its way into equity markets.
*The opinions and forecasts expressed are for informational purposes only and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. The representative does not guarantee the accuracy and completeness, nor assume liability for loss that may result from the reliance by any person upon such information or opinions.
[ii] Lombardi, Michael. Six Historical Reasons Why the Stock Market Is Near a Top. 13 Feb 2013. Benzinga. 13 Feb 2013. <http://www.benzinga.com/trading-ideas/technicals/13/02/3330101/six-historical-reasons-why-the-stock-market-is-near-a-top.>
[iii] Siegel, Jeremy J. The Case for Dow 17,000. 19 Nov 2012. Kiplinger. 14 Feb 2013. <http://m.kiplinger.com/article.php?url=%2Farticle%2Finvesting%2FT052-C019-S001-the-case-for-dow-17-000.html.>
[iv] Rates. 14 Feb 2013. The Wall Street Journal. 14 Feb 2013. <http://professional.wsj.com/home-page?mg=reno64-wsj.>
[v] New Bull Run – Already Started or Another 10 Years? Aug 2009. Finance Twitter. 14 Feb 2013. <http://www.financetwitter.com/2009/08/new-bull-run-already-started-or-another.html.>
[vi] Zweig, Jason. It’s Hard to Limit U.S. Stock Exposure. 1 Feb 2013. The Wall Street Journal. 14 Feb 2013. <http://professional.wsj.com/article/SB10001424127887323926104578277852612918328.html?mg=reno64-wsj.>
[vii] Federal Reserve Statistical Release: Factors Affecting Reserve Balances. 14 Feb 2013. The Federal Reserve. 18 Feb 2013. <http://www.federalreserve.gov/releases/h41/current/h41.htm.>
[viii] Bestand: U.S. Federal Reserve Balance Sheet. 18 Nov 2012. Wikipedia. 18 Feb 2013. <http://nl.wikipedia.org/wiki/Bestand:US_Federal_Reserve_balance_sheet_total.png.>
[ix] Biderman, Charles. How the Fed is Helping to Rig the Stock Market. 30 Jan 2013. Forbes. 18 Feb 2013. <http://www.forbes.com/sites/investor/2013/01/30/how-the-fed-is-helping-to-rig-the-stock-market/.>
[x] Bennett, Johanna. Are Analysts Too Optimistic About 2013? 18 Dec 2012. Barron’s. 19 Feb 2013. <http://online.barrons.com/article/SB50001424052748704379604578187303980582598.html#articleTabs_article%3D1.>
[xi] Winter 2013 Snapshot of Expected Future S&P 500 Earnings. Townhall Finance. 19 Feb 2013. <http://finance.townhall.com/columnists/politicalcalculations/2013/02/19/winter-2013-snapshot-of-expected-future-sp-500-earnings-n1515099.>
[xii] Aneiro, Michael. Funds Rotating Into Stocks, But Not Out of Bonds Yet. 7 Feb 2013. Barrons. 22 February 2013. <http://blogs.barrons.com/incomeinvesting/2013/02/07/funds-rotating-into-stocks-but-not-out-of-bonds-yet/.>
[xiii] Boesler, Matthew. Anyone Hoping For a Great Rotation Into Stocks Must See These Three Charts. 31 Jan 2013. Business Insider. 22 Feb 2013. <http://www.businessinsider.com/morgan-stanley-on-the-great-rotation-2013-1.>