Can This Remarkable Bull Market Continue?
On March 9, the bull market will celebrate its second birthday. The ascent has made investors giddy -- at least those who weren't permanently scared away from the stocks by the devastating 2007-09 bear market. Since the nadir in 2009, Standard & Poor's 500-stock index has more than doubled on a total-return basis -- that is, including dividends. Year-to-date through February 10, the index has already gained 5.3%. What is driving this remarkable ascent, can it continue, and do any bargains remain?
The answers, in short: Behind the surging market is an improving economic picture and boffo corporate earnings. Yes, the bull still has legs and could easily continue to charge for another six to 12 months. And the best opportunities are in the stocks of large, blue-chip companies.
Following the S&P 500's staggering 55.3% decline before and during the financial crisis, a sharp rebound was inevitable. But as the bear market was approaching its final days two years ago, many Americans wondered whether the country would soon be in a depression and bailed out of stocks as fast as they could hit the sell buttons on their keyboards. Few could have imagined the ferocity and persistence of the advance that would soon get under way.
But the surge in share prices has hardly been irrational. The market's rise owes much to the Federal Reserve Board's remarkably lax monetary policy, an improving economy, surging corporate earnings, and increasing inflows into stock funds from individual investors.
The employment and housing markets are still abysmal, but most other parts of the economy are on the mend. Manufacturing and exports are expanding. Capital spending -- especially on information technology -- is healthy.
Aided by tax cuts, consumer confidence and spending are up, especially among high income earners. Even bank lending, after many months of contraction, is starting to perk up. In recent weeks, economists have been steadily raising their growth forecasts for 2011.
Corporate earnings have outdone the economy. Firms have aggressively cut costs and boosted productivity. Booming emerging markets have spurred sales and earnings growth. Companies from Coca-Cola (symbol KO), McDonald's (MCD) and Starbucks (SBUX) to Deere & Co. (DE), Caterpillar (CAT) and DuPont (DD) have benefited enormously from strong positions in developing countries.
Analysts think that companies in the S&P 500 will earn a record $97.12 a share this year, then eclipse $111 in 2012. At the S&P's closing price on February 10 of 1322, the market trades at less than 14 times projected 2011 earnings. That is in line with historical price-earnings ratios.
The strengthening economy is helping to push up interest rates, which at some point will slow borrowing and spending, and restrain the stock market’s rise. But we're not there yet.
Jeffrey Kleintop, chief market strategist of LPL Financial, thinks the tipping point will occur when the yield on ten-year Treasury bonds reaches 5% (it’s currently at 3.63%). Historically, says Kleintop, stock prices and bond yields have tended to rise in tandem when rates have been low (moves that reflect optimism about improving profits and pessimism that stronger growth could lead to more inflation). But when Treasury yields burst through 5%, stocks and bond yields typically part company and stocks begin to suffer.
After the market's rapid climb, it's natural to ask whether any values remain and, if so, where they are. Merrill Lynch strategist David Bianco says that valuations of small-company stocks are stretched by several historical measures, such as price-earnings ratios based on estimated profits. Bianco prefers the stocks of large companies in the energy, materials, technology and capital-goods sectors, particularly because these industries operate globally.
Will Danoff, manager of Fidelity Contrafund, tends to agree. He likes large technology companies (information technology now accounts for half of domestic non-construction capital spending) and has a particular fondness for multinational companies with expanding businesses in populous emerging markets. He notes that the stores of Apple (AAPL) -- Contrafund’s largest holding as of Dec. 31, 2010 -- with the heaviest traffic are now in China. Recently, several of Danoff's largest positions -- including Coca-Cola, Nike (NKE) and McDonald's -- were in U.S. firms with strong global brands and rapidly expanding businesses in developing countries. (For more on Danoff's current strategy, see Where a Top Fund Manager is Finding Opportunities.)
What are the chances that the bull is still young and will live long enough to celebrate a third birthday next year? If history is any guide, the chance is 50%, says Jim Stack, a market strategist in Whitefish, Mont. Stack researched all the bull markets (measured from market bottom to market peak) over the past 80 years and found that 80% lasted more than two years and half lived to age three.
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