Corporate Profits: With the US stock market reaching new highs, the debate is on as to whether the market will advance further or sees a correction as it did the last two times prices soared to record highs. It is very difficult to predict this market, but there are two important features of the current market environment that set it apart from the past two peaks in 2007 and 2000: corporate profits are much higher and investor sentiment is still somewhat pessimistic. The level of corporate profits today is estimated to surpass $110.00 for the S&P 500 vs. $84.00 at the peak in 2007. This gives the current rally more fundamental support for stock prices compared to the last two peaks. Strong corporate profits bode well for economic growth, specifically driving job creation, capital spending and technological innovation.
Corporate executives have become more cost conscious over the past few years, which has boosted productivity and should provide the foundation for increased future earnings. The question is whether domestic consumer spending and global demand for U.S. products will expand enough to keep profits growing going forward. Emerging market growth has been flattening somewhat as their policy makers try to keep their economies growing while also keeping inflation in check. The latest research shows that growth in China will still be in the 7% range, which is a far cry from a “hard landing”. U.S. GDP and employment may also start to improve more meaningfully in the second half of the year if Congress passes a spending bill to remove some uncertainty. Economic growth also leads to increased tax revenue which will change the picture somewhat on deficit issues.
Investor sentiment is quite different now compared to 2000 and 2007 – based on both what investors are willing to pay for earnings and how they are allocating investable money between equities and fixed income. Due to the stress caused by the financial crisis and market collapse in 2009, a large percentage of investors remain on the sidelines. The S&P 500s P/E ratio is lower today than in 2007 which suggest investors are still relatively pessimistic about the future, even though interest rates are notably lower and inflation is less of a worry.
Perhaps the most fundamental difference between the current rally and that of the previous two is the Federal Reserve’s stance. Indeed, the Fed was tightening monetary policy prior to both previous market peaks – a far cry from the accommodative stance the Fed has struck in recent years. Globally, many central are maintaining a very similar accommodative stance which also bodes well for equities going forward.
According to a survey done by the American Association of Individual Investors released on May 2, only 52 percent of Americans currently own stocks. That’s the lowest level since they started the survey in 1998. Only 31 percent of investors describe themselves as bullish, well below historical norms, and nearly 36 percent are bears, well above historic averages. The demographics underpinning these facts may argue for caution, but they do not suggest that we are poised for a correction (absent, of course, some external shock). Instead, these studies suggest there are still some people out there who might, if things stay calm and stocks keep going up, have the money to give the market more gas.
• Stock prices are by no means stretched relative to economy-wide profits, and gradual improvements in the economy argue for continued profit gains. If rising prices drive sentiment instead of the other way around, investors’ appetite for equities could continue to strengthen – drawing in cash either from the sidelines or from other asset classes, further fueling an advance.
• The market may experience a short term correction based on any negative news over the next few months. However, the interest rate risk associated with bonds and the equity risk premium (the excess return of the overall stock market provides over treasuries) the trend is definitely in favor of equities in the future.