NEW YORK, N.Y. – Is it time to cash out of stocks?
The market has nearly tripled in a little over five years, and the Standard & Poor’s 500 index closed above 2,000 for the first time on Tuesday. With each record, the temptation grows to take your winnings and flee.
Plenty of experts think stocks are about to drop. But many others offer compelling arguments for the rally to continue for years.
The bulls point to a strengthening U.S. economy. They also like that companies have plenty of money to keep buying back their own stock.
The bears argue that stocks already reflect years of future profit gains. They also note that many economies around the world are stumbling and that U.S. interest rates could rise soon.
Remember, though, that even the best investors find it nearly impossible to time the market to catch the lows and highs.
The bull and bear cases in detail:
A STRONGER ECONOMY
Four of the past five bull markets have ended with investors selling in a recession, or bailing out because they anticipated one. The odds of a downturn anytime soon? Not very high, at least based on the latest economic reports and forecasts.
The U.S. economy is expected to grow 1.5 per cent this year, then 3.4 per cent in 2015, according to Congressional Budget Office estimates released Wednesday. One reason is companies are hiring at the fastest pace in eight years.
“This recovery will last several more years,” says Jim Paulsen, chief investment strategist at Wells Capital Management.
Analysts expect earnings from companies in the S&P 500 to rise 8 per cent this year, then 12 per cent in 2015, according to S&P Capital IQ.
LOW INTEREST RATES
Interest rates are low, and that’s been great for stocks. They help lower borrowing costs for consumers and businesses. They also hold down interest payments on bonds, making stocks look more attractive by comparison.
Many investors expect the Federal Reserve to start raising short-term rates in the middle of next year. If the Fed keeps the hikes small, the stock market might shrug it off.
That’s what happened in the last round of Fed hikes, in 2004. The S&P 500 gained 9 per cent that year.
Torsten Slok, chief international economist at Deutsche Bank Securities, notes that the short-term rates that helped drag stocks down at the end of the last seven bull markets were all higher than 4 per cent. With the Fed holding those rates near zero, it could take many hikes for borrowing costs to rise enough to cause damage.
One of the biggest forces in the stock rally so far is companies buying back their own shares. Companies in the S&P 500 have spent $1.9 trillion on buybacks since the bull market began in March 2009, according to Howard Silverblatt, a senior index analyst at S&P Dow Jones Indices.
By creating more demand for stocks, buybacks have kept prices rising even as other big investors sell. Mutual funds, investment brokers, foreigners and pension funds have been net sellers of stocks over most of the last five years, according to the Fed.
Companies have pulled back sharply from their near-record buying in the first quarter, but their buybacks are still pushing up prices. And companies in the S&P 500 still have more than $1.1 trillion in cash, according to S&P Dow Jones Indices.
STOCKS NOT CHEAP
It’s fine to forecast big profit gains well into the future, but what if prices fully reflect expected gains?
That’s what many bears think. They cite the price-earnings ratio, or the price of a stock divided by its earnings per share. If a share costs $100 and the company is expected to earn $5 per share in the coming year, the P/E ratio is 20.
The S&P 500 now trades at 15 times what companies are expected to earn over the next 12 months, according to FactSet. That is slightly above the 10-year average of 14.1.
The problem is, P/Es are often not reliable gauges of stock value. They are based on just one year’s earnings, which can rise and fall along with the economy.
Many experts believe a better P/E is a “cyclically adjusted” ratio, which averages earnings over 10 years.
It is currently 26. That’s far below the peak of 44 it reached in the late 1990s, but it’s still very high. Since the end of World War II, the average is 18.3.
THOSE COMING RATE HIKES
The Fed may be able to raise rates slowly without damaging the economy and stock markets. But its record isn’t entirely reassuring.
Three of the past five bull markets ended after the Fed increased rates.
If the central bank finds itself scrambling to contain inflation and has to raise rates sharply, stocks could fall 20 per cent. Inflation doesn’t appear to be a problem right now. But that could change fast if the economy heats up.
STRUGGLING ECONOMIES ABROAD
U.S. companies rely more than ever on foreign economies remaining healthy. Unfortunately, many of those economies are stumbling.
The 18 countries that share the euro didn’t grow at all last quarter. China is slowing rapidly and Japan shrank 7 per cent compared with a year earlier.
Most economists expect the U.S. to shrug off the troubles abroad. But not everyone.
David Levy, an economist, predicted the last U.S. recession with uncanny precision. He says another one is coming next year. The cause: Downturns elsewhere, not domestic trouble.
Even if he’s wrong, slowing economies overseas will still matter since companies in the S&P 500 generate nearly half their sales abroad.