What will be the key drivers for stocks going forward?  Valuations compared to historical levels as well as other asset classes, particularly bonds, should start moving money back into stocks.  While many strategists have recently argued that the ‘golden age of stock investing’ is now dead, we would point out that such pronouncements in the past have generally marked periods of lows in stock prices.  The shifts away from stocks has been far too dramatic; while the public has been liquidating stock funds and adding to bond funds for five straight years, the pension market has also been going the same way with bond allocations more than 10% higher than the levels seen in 2007 and stocks 10% lower.  Given our view that stocks are cheap and interest rates are at their lows, a shift back to stocks should ensue.  Given the size of the shift away from stocks over the past five years, the move back into the market could have a surprisingly large impact on stock prices.

The difference in valuations of stocks versus bonds is shown in the chart below, which shows the spread between the dividend yield on the S&P500 stock index versus the yield on 10-year government bonds since 1995.  While the spread was as much as negative 500 basis points at the peak of the stock market in 2000 (i.e. stock dividend yields were more than 5 full percentage points lower than government bond yields), it has been increasing slowly ever since that time and now sits 25 basis points above the 10-year bond yield.  The bottom line is that investors can earn a higher rate of return by owning the S&P500 index and collecting the dividends than they can earn in interest from holding government bonds.

Stock Dividend Yields vs Bond Yields

This anomaly seems to indicate that investors expect earnings to fall and stocks to fall going forward.  Investors are paying absolutely nothing for the potential growth in earnings.  When sentiment is this negative and relative valuations this attractive, it has always proven to be a good time to be an investor in stocks.

Since 2008, only one country has seen its forward profit margins expand persistently relative to the world: the U.S.  Driven by this better earnings progression, US equities have outperformed global equities.  But, can the US maintain the upward momentum in margins over the coming two years even in the face of the fiscal cliff in Q1 2013?  Three factors are likely to maintain this strong relative upward trend in profit margins. The current high US unemployment rate (8.3%) is likely to keep pay growth muted for some time; the US has the least rigid economy in the world, which means firms are able to rapidly adjust their cost structures to match revenue changes; and the U.S. has been the most intense user of new technologies, which reduce operating costs and increase profit margins.  While the Eurozone’s softness and the European recession have modestly hurt US margins (around 20% of US firms’ revenues come from Europe) profit margins remain near their highs.  This is one of the key reasons we have stayed overweight U.S. stocks in the global equities portfolio, with a focus on the key technology and industrial sectors that have benefitted the most from this expansion of profit margins.

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