How Can the Market Possibly Do Well?
Advisors Capital Management
By Charles Lieberman
July 23, 2012
Investors remain rightfully concerned that our leaders have
been unable to address major domestic and international issues.
Domestic growth is sluggish, job growth is weak, unemployment remains
high, the fiscal cliff looms at the end of the year and our politicians
can’t agree on the time of day. Moreover, none of this is likely to
become clarified until after the election, if then. Internationally,
Europe has a financial crisis at both the sovereign level and the
banking level, while unemployment is extremely high even as their
economy is already in recession. Global geopolitical concerns include a
possible attack on Iran’s nuclear weapons facilities, Iran’s threat to
close the Straight of Hormuz to oil traffic, civil war in Syria and
political turmoil in much of the Middle East, assorted unstable
dictatorships and autocrats in places like North Korea, Venezuela, and
other places. It is understandable that people are rather concerned
when faced with so much uncertainty. So, how can the S&P 500 be
approaching 1,400 and the DOW 13,000?
The equity market is priced for many uncertainties and it is cheap based on earnings. The S&P 500 hit 1,400 in 2000. According to Factset, combined earnings for those companies in the S&P 500 were around $51, but investors were far more optimistic, so the forward year price earnings multiple for the market was around 27x. The S&P returned to 1,400 by the beginning of 2007, but earnings had risen to around $81, so the multiple fell to 16x. Now, the S&P is almost back to 1,400, but according to Reuters, 2012 earnings are expected to be around $103 and 2013 earnings are projected at $107 (reflecting a cautious view of growth prospects), resulting in price earnings multiples as of Friday’s close to be 13.2x and 12.7x for 2012 and 2013, respectively. These multiples are well below average for the entire post-World War Two period.
The high level of caution is also evident in bond prices, not just in depressed stock valuations. Investors must pay for the privilege of lending money to the governments of Germany, Finland, Holland and must accept a negative real return on 10-year U.S. Treasury notes. We have seen negative real interest rates before, but not such deeply negative returns. So with people so nervous and cautious about the outlook, how can stock prices rise?
The stock market is a mechanism to value businesses. Those businesses are becoming ever more profitable, even with slow growth. So even if they are valued cheaply because people are worried about the future, rising corporate profits are forcing stock values higher. Just as people are quite willing to pay to own valuables assets, such as commodities like oil or steel, or income producing assets like real estate, they are also willing to pay to own stocks that pay good dividends or have the capacity to pay good dividends in time. As the profits of these companies increase, the value of the companies also rises, despite the prevailing high degree of caution. If the political and economic environment were more benign and more positive, valuations would be considerably higher. In the meantime, slow growth and moderate increases in corporate profits is sufficient to slowly drive stock prices higher.
(c) Advisors Capital Management