2 Reasons why there’s still room to run in stocksContributors Thomas Luddy, Susan Bao, Scott Davis
Sustained economic growth should power the market ahead
With the S&P 500’s valuation now above its historical norm and a disappointing earnings season, investors may question whether the bull market in equities has finally run its course. Such signs could well be a source of volatility, but we don’t believe they foreshadow the end of the run. Both the market itself and the real economy seem to point the way higher.
A growth bias
Notwithstanding where they rank relative to their market history, stocks remain undervalued relative to bonds. As shown in the chart, investment-grade corporate bond “P/E,” the ratio of a bond’s price to its yield, still exceeds the S&P 500’s consensus forward P/E. The anomaly has persisted since 2010 because of the stubbornly low level of real interest rates. As long as rates stay low—and we don’t anticipate them spiking to traditionally high levels anytime soon—corporations can borrow cheaply and buy back their own stock or buy other companies. Both actions support equity prices.
Alongside these benign market conditions, the real economy is growing, not very fast, perhaps, but with self-sustaining momentum. The employment picture has been steadily brightening, and the Conference Board’s index of leading economic indicators is quite positive. The second quarter’s earnings disappointments were largely confined to the energy sector. Ex-energy, S&P earnings grew in line with the historical trend, as our chart shows. Further, what’s bad for energy—falling oil prices—is not necessarily bad, and in fact may even be good, for other sectors of the economy.
Warnings and risks
Against this positive backdrop, we find little to indicate that a slowdown is imminent. In any event, historically there’s been a long lag between signals of a downturn and the onset of recession. In the past, it has taken about a year for an inverted yield curve, the classic symptom of diminished expectations, to translate into a business downturn. It has taken more than four years on average for a recession to follow on the Federal Reserve’s first rate hike of a cycle—and after nearly a decade we are still awaiting that first hike.
No scenario is immune to shocks, of course, and the current environment contains several threats—the Greek tragedy, the prospect of a hard landing in China and the ultimate certainty of rising rates in the U.S. —that might give investors pause. Of the three, we take the prospect of a Chinese hard landing most seriously because of that economy’s global importance. The strenuous measures the government has taken to date give us hope that it may steer past the most serious impacts, however. By contrast, the Greek situation, while extreme, should have limited consequences. The prospect of rising rates in the U.S. invites volatility, to be sure, but sound market fundamentals and a robust economy have typically powered past it.
Looking beyond the market’s day-to-day performance to the longer-term trend, we believe that stocks are in the midst of a secular bull market supported by an economy in the midst of an uninterrupted expansion. The view sustains four themes that inform our investment approach:
- The cyclical recovery favors economically sensitive sectors like technology and construction. We think it may prove particularly supportive of industrial durables. The ratio of durable investment to GDP has fallen chronically short of its long-term trend for some time now, and sooner rather than later business will have to replace aging equipment and plant.
- Interest rate normalization should benefit the financial sector. The sector’s typical performance is negatively correlated to the price of Treasury securities, which should retreat as rates rise. We feel that banks have room to expand net interest margins, and we anticipate that consumers and businesses will increase their borrowing as the cycle continues.
- Growth at a reasonable price appeals to us, because well-run companies with ample free cash flow can maintain and even increase their dividend—a compelling proposition in a time of minimal yields. Quality operations can also serve as long-range defensive holdings against a turn in the cycle.
- On the other hand, we are avoiding traditional defensive stocks. So-called bond proxies have been trading at a premium compared with their historical valuations, and their business models are based on economy considerably more constrained than the one we are anticipating.