Strong Equity Markets

12.02.2013

Strong Equity Markets

The stock markets have done well all year, with indices setting new records, recovering all the losses from the financial meltdown.  Just before Thanksgiving the NASDAQ closed above 4,000 for the first time in 13 years.

What’s behind the strong showing?  Continuing low interest rates make bonds relatively unattractive, pushing investors toward stocks.  What’s more, when interest rates eventually do rise, the value of existing bonds will fall.  That risk to principal has made many investors skittish about the longer bond maturities.

But another important driver of stock prices has been the improving health of American companies.  Operating earnings are near all-time highs, and profit margins are excellent.  According to the Federal Reserve, as of March 2013 after-tax profit margins were approaching 10% of gross national product, well above historical averages.

Consumers have been deleveraging since 2009.  Household debt service as a percentage of disposable personal income has fallen from over 14% in 2007 to under 11%.  That drop could permit an increase of consumer spending in the coming year.

Housing prices have stabilized in much of the country.  In the second quarter of the year, 80% of zip codes experienced home price increases.  The price-to-rent ratio, which spiked in 2006, has now fallen back near 2001 levels.  That should draw more buyers into the market.

Meanwhile, there’s no sign of a major uptick in inflation.

Given these strong fundamentals, are equity valuations reasonable?  Some market observers believe that today’s stock prices fall within the upper half of the “fair value” range.  The cyclically adjusted price-to-earnings ratio divides current stock prices by the average of the prior ten years’ earnings, adjusted for inflation.  That metric peaked at well over 40 during the Internet bubble of the late 1990s.  It was over 25 before the financial meltdown. Now it’s at 23.7.  At that level, one might say that the easy money already has been made in stocks, but there is still upside potential while the downside risk is not severe.

The future actions of the Federal Reserve remain the great uncertainty.  Someday interest rates will have to rise again.  The path to an end of “quantitative easing” remains cloudy, however, because we’ve never before had such a sustained period of low interest rates. The full consequences of a return to what most would consider “normal” wait to be seen.

(December 2013)

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