The US stock market appears to be facing a more hostile environment. Record high profit margins and sluggish sales trends suggest slower future earnings growth; bond yields are finally rising; and the Federal Reserve may soon take away the liquidity punch bowl.
The stock market may pause for a few months to digest these changes. But while many investors have turned cautious, the bull market has probably not ended. This is because the primary force driving the stock market is not earnings performance, low yields or quantitative easing; rather, it is a slow but steady revival in confidence, a trend that is just beginning.
In this scenario, investors need not be overly concerned about slower earnings growth. While earnings are obviously important, stock prices have frequently diverged from earnings trends. In fact, for the third time in the postwar era, stock prices and earnings are repeating a remarkably similar three-stage cycle.
First, earnings surge while the stock market remains essentially flat (the earnings production cycle). Second, earnings performance flattens while the stock market surges (the valuation cycle). Finally, both stock prices and earnings move in tandem (the traditional cycle). It appears the contemporary bull market has just entered the second phase, making earnings growth less important.
Earnings nearly tripled between 1945 and 1951, and again between 1970 and 1982, and they have more than doubled since 2000. In all three episodes, however, the stock market remained essentially unchanged.
In both the 1950s and the 1980s, the earnings cycle was followed by an explosive stock market run despite almost flat earnings performance. Between 1952 and 1962 the market rose about 3.5 times, while from 1982 to about 1994 it surged almost fourfold.
In the contemporary era, since autumn 2012, despite earnings growth slowing to low single-digit rates, the price-earnings multiple has risen from about 13 times to about 16 times. If this means the stock market just entered its third “valuation cycle” of the postwar era, is slower earnings growth really that worrying?
One concern is that the recent rise in US bond yields will abort the stock market bull run. But rising bond yields reflect improving economic confidence, rather than increasing inflation expectations or concerns about the creditworthiness of the US government. A rise in bond yields predicated on a growing belief the “world will not soon end” hardly seems bad for the stock market. Indeed, since 1967, when bond yields have risen in tandem with consumer confidence, the stock market has advanced at almost 12 per cent a year.
Another worry is that Fed “tapering” will end the stock market party. The Fed’s exit strategy may well create some indigestion, but we expect the “Great Fed Myth” – that the economic recovery and the stock market are simply sugar highs delivered by the Fed – to be debunked during the rest of this year.
The surprise entering 2014 may be that, despite a 10-year Treasury yield close to 3 per cent and far less bond purchasing by the Fed, both the stock market and the economy remain relatively steady. Indeed, if the economic recovery persists and is finally perceived as standing on its own, stopping QE could actually prove beneficial by lifting private sector confidence.
Since 1900, there have been three major bull markets, in the 1920s, 1950s-60s and the 1980s-90s. Both the first and the third of these were driven by a persistent decline in interest rates, an option not feasible today. However, the 1950s-60s bull market was characterised by a simultaneous rise in both stock prices and bond yields, driven by rising confidence.
As it was after the Great Depression and the second world war, confidence has been shattered since 2000 by numerous events. Now, if confidence is slowly rebuilt, perhaps the next several years will echo the 1950s. A numeric example highlights the possibility.
Conservatively, S&P 500 earnings per share should be close to $107 by year-end. If the recovery lasts five more years and earnings grow modestly at a 4 per cent annualised pace, they will rise to about $130. The current price-earnings multiple is about 16 times. If confidence measures eventually reach previous recovery levels, the stock market PE multiple should advance to about 20 (as it did in the 1960s). This implies a 2,600 target for the S&P 500, or with dividends, an annualised five-year return in excess of 10 per cent.
Certainly earnings, bond yields and Fed actions will create some turbulence along the way. But beware of becoming too myopically focused on these mainstream issues lest you miss what could be the second confidence-driven bull market of the postwar era.
James W. Paulsen is chief investment strategist at Wells Capital Management, a business of Wells Fargo Asset Management
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