Tuesday’s record setting close in the Dow Industrials was another reminder of how far equities have come in a relatively short time. Stocks in the United States are up roughly 20% from last summer’s lows.
Why? Fundamentals in the United States are generally favorable. Economic growth is slow, but corporate profitability is high and interest rates and inflation are both low. In addition, last summer investors were positioned much more defensively given concerns over Europe and the fiscal cliff. Though neither issue has been totally resolved, investors have celebrated the lack of a crisis by driving up stock multiples.
But while the rally has been good fun, I’m getting a lot of questions from investors about what comes next. Here are the questions, and my answers, below.
Q: Are US stocks still cheap?
A: On an absolute basis, stocks still look reasonably priced by most metrics. The S&P 500 is currently trading for roughly 15x trailing earnings, a bit below its long-term average of around 16.5. Valuations appear even more reasonable after adjusting for inflation, interest rates and corporate profitability. [Dow Industrials, Transports Both at All-Time Highs]
Perhaps most importantly, stocks look very cheap relative to the alternatives: bonds and cash. Based on a comparison of the earnings yield on the S&P 500 to the yield available on an investment grade bond index, the S&P 500 appears to be the cheapest it has been in more than 30 years. While this is as much a matter of bonds being expensive as it is of stocks being cheap, equities offer the better long-term prospect, even after the recent rally.
Q: Can US stocks still move higher?