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Is this rally for real?

Hurdles remain

After three gruelling years of negative returns, investors may be starting to chin up. So far this year, major stock market indexes are in positive territory. Bonds have done okay and high yield issues have seen decent gains. However, is this recent strength another teaser or does it have staying power?

The numbers

You wouldn’t know it by the gloomy media headlines, but stocks have done quite well this year. Canadian stocks, as measured by the S&P/TSX Composite, have gained nearly 9 percent on the year (as of yesterday). U.S. stocks, as measured by the S&P 500, have gained nearly 12 percent – though the 13 percent gain in the Canadian dollar has made that a 1 percent loss for Canadians holding U.S. stocks.

The tech-heavy Nasdaq 100 index has risen more than 14 percent in Canadian dollar terms. Given the Canadian dollar’s rise of 13 percent against the U.S. dollar, the Nasdaq has actually gained more than 27 percent in local currency terms.

For all of these markets, it’s a long way from their respective peaks, but they are healthy gains nonetheless.

Investor sentiment

In the U.S., where returns look more attractive thanks to a falling U.S. dollar, stock mutual funds are again attracting new money. In Canada, with most stock funds still in the red (again mainly because of currency), stock funds have experience twelve consecutive months of net redemptions (i.e. more money pulled out than invested into funds).

While Canadian investors seem a bit more cautious than their American counterparts in terms of investing new money into stocks, it’s likely that another strong quarter of stock returns will start to pull investors back into the stock market.

But does this rally have legs?

Market opinions

Indeed, a number of technical analysts believe it does – at least for a while. Ron Meisels, a long-time market technician with P&C Holdings Ltd., predicted in the Globe and Mail early this year that we were entering a new bull phase. In the article, author Rob Carrick writes of Meisels’ view, “He sees the S&P/TSX composite hitting somewhere between 8,500 and 9,000 by the end of the year, the Dow hitting the 10,000 range and the S&P 500 about 1,150”.

He’s not alone. Other technical analysts and more growth-oriented fundamental analysts concur with the view that this rally has a way to go and that healthy gains lie ahead.

However, there are other more traditional value managers who are starting to see valuations reach a high point. Staunch value disciple Irwin Michael, owner and portfolio manager of ABC Funds, says in his monthly commentary that prices of many stocks have gone up of late. Finding new opportunities after divesting a few holdings is a challenge. While he’s watching a handful of stocks that he likes, valuations have yet to fall into his “buy zone”.

Of course, it’s the diversity of such opinions that makes a market.

Valuations

I tend to lean toward the “value” school of thought. While earnings are near a cyclical low, the market continues to look expensive from the viewpoint of many valuation measures. Consider the following stats on the S&P 500 (source: Barra as of June 30):

  • Price-to-earnings (P/E): 30x
  • Price-to-sales (P/S): 1.43x
  • Price-to-book (P/B): 2.93x
  • Dividend yield: 1.89 percent

No matter how you cut it, today’s prices are expensive. At 30 times earnings, the aggregate earnings growth rate of the 500 companies comprising the index would have to approach 12 percent annually for several years in order to deliver 10 percent annualized investment returns to investors.

If inflation sits around 3 percent annually (the historical average), we’re looking at “real” earnings growth of nearly 9 percent annually. That’s six times higher than the median real earnings growth rate of U.S. companies over the past seventy-five years.

However, Many say that today’s low real interest rates justify higher valuations than in the past. But I’d counter that it’s not today’s rates that matter – but tomorrow’s rates.

If you believe rates will stay low, then you’re likely buying into a multi-year “low growth” economic scenario. However, big earnings growth across the board cannot occur within an economy that is posting modest growth figures.

The flipside, a scenario with a faster growing economy, means inflation will run up above average. But then the “real” growth of profits and stock prices will be diminished. One way or another, it seems that valuations may have run up a little ahead of the underlying fundamentals.

Admittedly, I’ve reviewed this issue somewhat superficially. But my views are backed up by the opinions of some of the country’s most highly skilled money managers. Don’t bet the farm on any direction – particularly a raging bull. Stay diversified. It’s a cliché that’s getting old, but it’s a healthy advice.

Dan Hallett, CFA, CFP is the President of Dan Hallett and Associates Inc., an independent investment research firm based in Windsor, Ontario. Dan can be reached at dha@danhallett.com.

 

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