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Economic Insights

Conditions appear favorable for the next 12–24 months. What could change the market's prospects in the longer term? Here's a look.

It has been quite a stock market rally. Some, in response to recent rapid gains, worry about a near-term correction. Of course, the market is always vulnerable to a correction. A string of disappointments on the economy or a policy frustration could easily create a temporary downdraft. On a more fundamental level, some fret that the gains have extinguished the value once so evident in the stocks and so impaired the market's future potential. That is very likely an overstatement. Stocks, though pricier than they once were, retain enough value to support further gains, even in the current mediocre economic and policy environment. On a longer-term basis, however, as the market realizes this remaining value, further gains will depend on more problematic, fundamental economic and policy improvements.

Stocks have gained impressively in recent years and months and, remarkably, have done so in the face of a poorly performing economy, severe policy failures at home and abroad, and intense investor caution, if not outright pessimism. From the lows of March 2009, during the last great recession, the S&P 500® Index1 has risen more than 100%, to its present level. If few bought into stocks during that frightening time, those who refused to buy or lost their nerve and sold out lost a great opportunity. During 2012 alone, though neither the economy nor policymakers gave investors much to cheer about, S&P prices rose some 16%. So far this year despite continued subpar economic growth, an ongoing fiscal/financial crisis in Europe, and at best the mere muddle in Washington's budget policy, stocks through mid-May have gained nearly another 16%.

Two things have enabled those impressive price gains in the face of what looks like a fundamental disconnect on the economic and policy fronts. First and most obvious, the Federal Reserve has pumped a flood of liquidity into the financial system. In just the last 12 months, for example, the basic provision of what is called the monetary base has expanded almost 15%.3 However cautious people are, that flood of liquidity has had an effect. Second is value. Stock prices and earnings were inordinately depressed when this rally began, even relative to the dire economic circumstances of 2009. At such values, price gains have had support even in the face of subpar economic growth and policy missteps here and abroad. The Fed's success in keeping interest rates low made what was already good value look comparatively better. And remarkably rapid earnings gains earlier in this recovery, despite the slow recovery, reinforced the pricing.

Looking forward from this history to likelihoods over the next 12–24 months, the rally would seem to have staying power, despite the price gains to date. Certainly, the Fed shows no sign of stemming the flow of liquidity. Among its other policy measures, it seems determined, for instance, to sustain its latest quantitative-easing effort by injecting $85 billion each month into the system. And the pattern seems set to last for a good while. Admittedly, some debate among Fed officials leaves a measure of ambiguity on this front. But Chairman Ben Bernanke still talks about 2015 as the earliest date for the Fed to make any substantive policy shift, and even the most hawkish Fed officials talk about only the most gradual turn away from the present policy.4 At the same time, stock values, though not as drop-dead gorgeous as they once were, remain extremely attractive.

There are, of course, a number of ways to measure value, but all today tell a similar story. Even after all their past gains, stock prices stand today at about 15 times historical earnings.5 Such price-to-earnings multiples remain well below old highs, and are indeed little different from where they have averaged during the past 35 years. Relative to bonds, stocks show even greater value. Current earnings, for example, measured as a yield on current stock prices, stand presently five percentage points above 10-year Treasury yields and three to four percentage points above various averages of corporate yields.6 Historically, such stock earnings yields (as they are called) average less, not more, than these bond yields. The picture suggests that prices have room to rise (bringing down earnings yields) before stocks look anywhere near pricy, even if bond yields were to tick up. Dividend yields, too, speak to value. Even now, after all the market's gains, most dividend-paying companies still offer a higher up-front dividend yield on their stocks than they pay on their own bonds. Stock prices would have to rise to a level sufficient enough to reverse that relationship before stocks could be described as expensive.

Longer term, however, the picture presents questions. In the fullness of time, the Fed will have to adjust policy and allow interest rates to rise. In all probability, investors will anticipate the monetary policy change and push up longer-term yields, where the Fed has less control, before the actual policy shift occurs. Rising rates and yields will, of course, begin to erase comparative equity valuations. To be sure, current measures favor equities enough to sustain value in the face of initial rate increases, and the Fed will almost surely move very gradually. But in time, the change will proceed, and it will affect markets. At the same time, likely further stock price increases will also tend to erase value, especially since the pace of earnings growth has already slowed. At present valuations and in the context of the slow adjustment anticipated in bonds, stock prices would seem to have 15-20% more room to rise before even approaching a point when value would become questionable. But as equities reach that point of full valuation, this current rally will require positive fundamental news from the economy or policy to sustain itself.

There are possibilities for such good longer-term news. Washington could, for instance, settle on pro-growth tax reforms. Such an event may seem remote at the moment, but both sides of the aisle and both houses of Congress have in fact proposed very similar measures to simplify and broaden the tax code and generally make it intrude less on economic and business decisions. Separately, the "fracking" revolution promises cheaper, more reliable energy that in time could do wonders to accelerate the pace of economic growth—not just in the United States but globally. It would equally enhance earnings prospects across a wide swath of the corporate world. But these and other less obvious supports still remain doubtful, and are hardly the basis for current portfolio positioning. Fortunately, investors do not need to decide yet. Since during the next 18–24 months they will likely retain the support of good values and a continued flow of Fed-provided liquidity, they can enjoy likely equity advances while the picture of this longer-term fundamental future becomes clearer. Only then will investors need to consider adjusting their portfolio positions accordingly.


1 The S&P 500 ® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.
2 All data from Bloomberg.
3 The Federal Reserve.
4 Ibid.
5 Bloomberg.
6 Ibid.

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