The stock market seems to be at a cross roads over the past few months as it consolidates the gains of the last five years. While the Canadian market is finally showing some leadership this year, helped by strength in the Energy sector, the U.S. market has run into some problems with the ‘momentum stocks’ that lead the market over the past two years. Biotech and internet stocks are more than 15% below their highs set earlier this year. It’s probably a good time to step back and look at the longer term picture of the market. Many stocks have risen a long way, not only from the absolute lows of this market in March of 2009, but also from the uninterrupted run-up from the lows seen in June 2012.

While we remain in the longer-term ‘bullish’ camp, we recognize that the stock market has come up a long way and can no longer be considered ‘cheap.’ The price-earnings ratio for the S&P500 is about 16.5 today, slightly higher than the long-term global average of 15.5 times and well above the low of under 10 times seen in 2009. While continued low interest rates support the argument for a higher earnings multiple on stocks, we may have pushed that argument as far as it can go in the short term. Stocks will need earnings growth to resume to support further price gains. On that count, however, we think the news is getting better as almost 75% of companies reporting earnings so far this quarter have met or exceeded their guidance, comfortably above the 65% average rate of ‘earnings beats.’ More importantly, forward guidance is coming in ahead of expectations, suggesting that earnings momentum is starting to pick up again.

This fits in with the recent economic data that we have seen that supports the view that much of the economic weakness over the past few months had more to do with the severe weather disruptions seen in North America. Bank loans, homebuilders, truckers, auto goods and retailers all reported significant pick-ups in their businesses over the past month, helping to push the widely-followed ISI Survey to its highest level in eight years! The chart, shown below, is one of our favourite forward indicators since it encompasses such a wide range of industries and is reflective of very current views. After being in a ‘slow growth’ band for much of the past three years, the surveys have recently ‘broken out’ to the upside, supporting our view of stronger growth in the second quarter.
Spring Growth in US Economy
But we do have to pay some homage to both sides of the stock market views, including the growing consensus that is expecting anything from some kind of ‘correction’ in the short-term to a complete give-back of the gains of the past few years. The bearish arguments are driven in large part by the skepticism over the sustainability of profit growth.

The consensus is looking at $120 a share this year for the S&P500. But the skeptical view on earnings is that they are inflated because corporate profit margins are at a 60-year high, and they are 70% above the average of the past six decades. If you assume that margins will recede back to long-term levels then normalized earnings are well below that estimate of $120 a share. On that basis, the S&P500 is probably trading closer to 19 times earnings, well above long-term averages. The argument over the sustainability of margins near these levels goes directly to the factors that have gotten them there. First has been a lengthy improvement in corporate productivity. On top of that we’ve had years of fixed-cost reductions by corporations as they’ve cut to the bone. Also, low labour costs have helped. But if the employment market gradually tightens, labor costs will rise, pressuring margins. Finally, the bearish argument goes, both interest expenses and effective tax rates will have to rise as central banks normalize monetary policy and the U.S. is forced to reduce its deficit.

So if you accept the view that the current corporate profit cycle, boosted by low interest rates and labor costs won’t last forever and will revert to the mean, then the market is over-valued today. The bearish view takes it a step further as well, pointing out that a better measure of stock prices is “stock-market valuation to revenues”, which currently stands at 1.67 times the S&P500—the highest level since the 2000 market high, and double historic norms!

There is also the view that stock investors are feeling unduly protected by the renewed confidence that the lessons Fed and other government officials learned in the Great Recession about how to reverse market crashes and revitalize economic growth will protect them from another downturn. We don’t think investors are that naïve. The “Greenspan and Bernanke Puts’ (i.e. record low levels of interest rates) didn’t save the stock market from two nasty 50%-plus stock market crashes in 2000-2002 and 2007-2009.

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