Equities have since picked up where they left off and, year-to-date, most major indices are up by double-digits. Front-of-mind for investors is whether this momentum can be maintained. Here are the bear and bull cases as well as our thoughts on what may lie ahead.
The bear argument
Bears cite numerous reasons for their scepticism regarding the continued momentum of equities. The magnitude and pace of the recent stock market climb is the first case for many: a six-month run of 29 per cent is indeed a high-octane return.
Sceptics point out that the biggest risks to the economy still remain. Sovereign debt worries in Europe continue to loom large, and some fear that political progress could hit a roadblock and unravel. In both 2010 and 2011, the year began with a similar pattern of optimism and positive data, only to be stymied mid-summer with political and fiscal flare-ups in the eurozone. This year could be headed down the same path.
In the US, many cite the high level of unemployment as a continued headwind, both to the fragile recovery of the housing market and to consumer spending trends. While recent unemployment numbers have posted reassuring retreats, economists point out that the lower percentage of unemployed reflects, in part, that many frustrated job seekers are abandoning their search. As the labour market improves, this crowd may resume its place in the data, pushing the unemployment rate higher despite other improved measures.
Finally, inflation is a key concern – particularly in terms of climbing oil prices. Higher global demand has the unfortunate effect of upward pressure at the tank, which in turn acts like a tax on consumers. The continued political instability in Iran continues to be particularly worrisome, but even without that wild card, higher oil prices may start to cool the activity of consumers and businesses, and in turn, the equity markets.
The bull argument
While the bears have various arguments for stock market weakness, current bulls have their own reasons to expect further gains. In 2011, there was a significant disconnect between the 14 per cent earnings growth of S&P 500 companies and the index’s relatively modest 2 per cent total return. While the sovereign debt crisis, growth fears and other macro issues undermined investor confidence, actual company performance plugged along at a relatively steady pace. As such, many bulls argue that the S&P 500 and other equity indices are simply catching up to their justified levels, rather than inflating at an undue pace.
Despite the 29 per cent climb, valuations based on price-to-earnings and dividend yield metrics are well within the range of historical norms. At mid-March, the P/E ratio on the S&P 500 (based on one-year forward consensus earnings) was about 13, versus a 10-year average of almost 15. The current dividend yield on the index is about 1.9 per cent, or about in line with the 20-year average of 2.1 per cent. If either continued earnings growth or a P/E expansion materialise, the equity markets could maintain their climb.
Some observers see reason for even more optimism – based on the idea that improving economic fundamentals create a positive feedback loop leading to further improvements. GDP growth, at its current pace, could support these trends.
Finally, global monetary policy has been a tailwind, and could help equity markets along their current path. In the past six months policymakers have taken 115 actions to add to liquidity and ease conditions globally through rate cuts, lower loan reserve ratios and other measures. Current modest inflation levels, coupled by further easing cycles, could keep loose conditions in place and support equities.
Our view
Given all these factors, where do we come out? Markets have moved a long way in a short period, so we think it is likely there will soon be a pause – perhaps for a month or two, as investors catch their breath.
For the year ahead, our outlook is for a modest rise in equities – driven by P/E expansion – assuming the absence of significant shocks that can undermine even the most thoughtful forecasts. Longer term, we believe that company fundamentals and economic growth will continue to support significant weightings in, and relative optimism on, equities.
Matthew Rubin is director of investment strategy at Neuberger Berman. The views expressed here are his own.