If last year’s bull market was a "stealth" rally that many investors didn’t even know existed, this year’s advance has been impossible to miss. But it’s a tale of two markets, all bullish on the outside, full of skepticism within. The market, measured by Standard & Poor’s 500-stock index, has returned 16.6% so far this year, smashing records in the process. But as market indexes scaled new heights, second-guessers wondered whether it was time to get out — before many sidelined investors had even gotten in.
We think the bull market has life left in it. That's especially true for long-term investors who can weather the inevitable pullbacks and pauses. The U.S. stock market, and in particular large-company stocks, remains compelling.
And with interest rates low and virtually guaranteed by the Federal Reserve to remain so through year-end and into 2014, stocks face little competition from bonds or savings accounts. "From here to the end of the year, the market will go up enough that stocks are the right place to be versus alternatives," says Bob Doll, chief stock strategist at Nuveen Investments. "But the pace of gains will be noticeably slower." (Returns, prices and yields in this article are as of May 29.)
More gains coming
The market's breathtaking advance has surpassed many people's expectations including ours. In our January outlook we predicted that the S&P could return 9% this year, which it accomplished by the end of the first quarter. We now think stocks will end the year with percentage returns in the mid to high teens, which means they'll manage to hang on to what they've logged so far, with some ups and downs likely along the way, and maybe tack on more.
Investors are proving themselves willing to pay more for every dollar of corporate profits, even if profit growth itself is moderating. "Now, it's not about earnings, but about the value you place on those earnings," says Jim Paulsen, chief market strategist at Wells Capital Management. In a shaky economic recovery, investors are reluctant to pay up for profits when it's unclear how fast, or if, they can grow. Coming into 2013, says Paulsen, people started to believe that economic growth looked sustainable. "Not fast, but sustainable. That's a big deal for the valuation of stocks," he says.
Stocks are trading at 15 times estimated 2013 earnings, compared with just 13 times a year ago. Is the higher price-earnings ratio justified? Consider: At market peaks in 2000 and 2007 (levels close to where the S&P 500 recently traded), stocks sold at 25 and 15 times estimated earnings, respectively. Corporate profits, however, are higher today, and companies are paying out more of those profits as dividends; inflation and corporate debt in relation to asset levels are lower. Also, interest rates on competing bond and savings investments were higher at the previous peaks.
Signs of economic growth have been encouraging, but spotty. Kiplinger expects gross domestic product growth as low as 2% this year, clipped by the forced government spending cuts that took effect in the spring, and 2.9% in 2014. But consumers have remained remarkably resilient, the housing market is picking up steam, and the most recent report showed that the unemployment rate fell to 7.5% in April, the lowest level since December 2008. "Markets don't move on absolutes of good and bad," says Richard Bernstein, CEO of Richard Bernstein Advisors. "They move on better or worse. The economy might not be good in an absolute sense, but it's hard to argue that it has not improved."