By GREGORY ZUCKERMAN
The market is surmounting a wall of worries to approach all-time highs. The best news: There are reasons to think the good times will continue.
After a choppy run last week, the Dow Jones Industrial Average is up 7.5% for the year while the Standard & Poor’s 500-stock index is up 6.5%. The Dow is now just 75 points from its all-time high, reached on Oct. 9, 2007, while the S&P 500 is 47 points away from its record, set on the same day six years ago.
Behind the sharp recent gains: impressive corporate earnings, a rebounding U.S. housing market and improvements in Europe and China. Continued indications that the Federal Reserve isn’t eager to raise interest rates any time soon also are helping stocks, by keeping bonds unattractive and allowing companies and individuals to borrow money at puny rates.
The climb has come despite hand wringing about a string of issues, from a political squabble that has forced cutbacks on the government to a U.S. economy dealing with lackluster growth.
Stocks remain reasonably priced, despite the market’s gains since November, so investors shouldn’t race for the exits, some analysts say. Stocks in the S&P 500 index trade at less than 15 times their earnings over the last year, and about 13.5 times their expected earnings over the next 12 months. Both are reasonable multiples based on historical ratios.
Stocks also look attractive based on cash flow, which many investors argue is a better barometer of a company’s strength than reported earnings. Stocks trade at a “cash-flow yield,” which reflects a stock’s cash flow as a percentage of its price, of about 7%.
That figure has come down over the past year, suggesting that stocks have become less attractive during that time.
But the 7% figure is in line with the average of the last three years and higher than the entire previous decade. For the first time on record, the cash-flow yield of stocks is higher than yields that junk bonds currently pay, suggesting that stocks are more attractive than junk bonds, according to BMO Private Bank.
Stocks are fairly priced relative to traditional metrics, like earnings and revenues,” says Jack Ablin, chief investment officer of BMO Private Bank. “They’re cheap relative to bonds.”
Meanwhile, the dividend yield of the 100 largest companies in the S&P 500 is expected to be about 2.6% this year, well above the 1.9% yield of 10-year Treasury notes. That’s another reason to think stocks are more reasonably priced than bonds, a reason money has shifted to equities from bonds.
A spate of recent mergers and buyouts is more good news, some argue. Billion-dollar deals for Dell, H.J. Heinz, Virgin Media and other companies suggest to some that stocks are attractive because savvy buyers are willing to make these big purchases.
“If investors, treasurers and arbitragers get more optimistic, we could see more” buyouts, takeovers and stock buybacks, which might help stocks, Mr. Ablin says.
While individual investors are beginning to get more excited about stocks, they’re still sitting on piles of cash, suggesting more money could move into the stock market. Over the past four years, investors have plowed more than $1 trillion into bond mutual funds, while pulling $500 billion from U.S.-oriented stock funds, according to Citigroup.
“Investors may be on the cusp of a major reallocation back toward equities,” argues Tobias Levkovich, Citigroup’s chief U.S. equity strategist.
To be sure, the valuation picture isn’t quite as rosy based on other metrics. One favored by Robert Shiller of Yale University that measures stock prices against average corporate earnings of the last decade shows stocks trading at nearly 23 times earnings, well above the historical average of 16. Some favor this measure because using a decade of profits makes it less volatile.
Bears also worry that profit margins are at record peaks and likely to fall, and that the U.S. and global economies remain fragile. Economists expect the U.S. economy to grow about 1.5% this year, a meager figure that comes on top of growth of just 0.1% in the fourth quarter of last year. Goldman Sachs predicts growth will be 2.9% next year and that investors will begin to anticipate the improvement later this year.
For now, markets have largely shrugged off the continuing tussle in Washington between the Obama administration and congressional Republicans over the budget, though the resulting across-the-board budget cuts—which started taking effect on Friday—will serve to further slow the economy.
In the bond market, there’s more evidence of danger. Junk bonds and other riskier debt have been so popular, and the volume of new sales of junk bonds has been so strong that some economists and analysts have turned wary. In early February, Federal Reserve Governor Jeremy Stein said “we are seeing a fairly significant pattern of reaching-for-yield behavior,” or investors buying riskier debt with higher yields.
William Gross, manager of the world’s largest bond fund at Pimco, recently wrote that stock and bond valuations are becoming stretched, but not yet at levels where investors should sell the bulk of their portfolios.
“On a scale of 1-10 measuring asset price ‘irrationality,’ we are probably at a 6 and moving in an upward direction” he wrote.
What investors need to do, Mr. Gross argues, it to stay invested in the market, but temper their expectations about future returns.
“Recent double-digit returns are unlikely to be replicated,” Mr. Gross wrote, pointing to potential annual gains of 5% to 6% over the next few years.
Over the next few months, James Paulsen, chief investment strategist at Wells Capital Management, argues, the fiscal drama and Europe’s challenges won’t matter as much for the market as whether the U.S. job picture improves. What to watch out for: housing and retail sales further strengthening, and investors shifting even more of their holdings from bonds to stocks.
Write to Gregory Zuckerman at gregory.zuckerman@wsj.com
