Welcome to the Autumnal Equinox.
Stocks rose last week as investor tensions were allayed regarding the Fed's interest-rate policy and the disintegration of the U.K.
Yellen and Co. asserted their commitment to keep interest rates low for a "considerable time" after its final $15 billion asset purchase in October. And, to the chagrin of Sir William Wallace, Scots voted to maintain their role within the British empire.
Investors appear at odds with the markets future direction. Which, for contrarians like you and I, is exactly what you wish for. Even as we sit near all-time highs, institutional and retail investors question the veracity of the bull market. And denigrate its continuance.
Yet, this rally has not been elevated on the backs of equity buyers. Participation among retail and institutional investors has hit record lows in recent years. Most of the brokerages, lemmings they are, continue advising clients to avoid equities.
Even Fidelity, renowned equity fund company it may be, has only 47 percent of its assets in stocks. In fact, its biggest fund is a cash management fund. Which, given today's rate environment, isn't helping anyone.
So, investors still don't buy this bull market. Concurrently, price-to-earnings multiples are plateauing. Meaning that future stock appreciation will be driven by corporate earnings growth. Which likely translates to a mean-reversion period that spells the end of 20-percent plus returns each year.
Once again, the party ends before most investors even bid adieu to the babysitter.
Still, just because the big gains are behind us, does the party have to end? Probably not.
Historically speaking, stock valuations continue to look cheap compared to bonds. The 10-year Treasury yield is 2.61 percent. Considering a forward-looking S&P 500 P/E of 16.8. So, if we want to compare valuations between the stock and the bond markets, you take the inverse of the P/E multiple (119 / 2000 = 5.9%) and compare that to the yield on the ten-year Treasury (2.6%). So, if you privatized the entire S&P 500 and aggregated the corporate earnings of all the index's member companies, you'd earn twice the yield of ten-year Treasuries. Not to mention the opportunity for future growth prospects.
Historically, when stocks were overvalued during periods of excessive speculation, the yield on ten-year Treasuries exceeded that of the S&P 500.
So, the S&P 500, relative to fixed income, is not overvalued. Not as long as interest rates remain low. Which begs the question, when and how fast will rates eventually rise?
Rates can remain low so long as the Fed does not detect pending inflation. But, given our massive budget deficit, and the fact that we will not be able to tax or save our way out of it, won't the government eventually have to inflate the debt away? So leading us to conclude that inflation is lurking around the corner?
Yet, the rest of the world is staring into recession's abyss. Both Europe and Japan are looking at deflationary situations. And China is doing everything it can to artificially enhance its banking system. Given those realities, low interest rates could remain intact for a much longer period than most expect.
Seriously, do we really think that Mrs. Yellen is going to risk tossing out the baby with the bathwater prior to ascertaining that the global economy is on solid ground? We doubt it.
So, this market will continue to benefit by low interest rates. So long as the ten-year yield does not jump too high, and the S&P 500 P/E multiple does not appreciate too markedly, that will continue to be the case. At least until inflation appears and interest rates begin to rise. That would change the entire narrative. And portend market difficulties.
When the S&P 500 earnings yield intersects that of the ten-year Treasury, we will head for the sidelines.
Major markets finished higher last week. The DJIA rose 1.72%, the S&P 500 gained 1.25%, and the Nasdaq advanced 0.27%. Small cap stocks declined 1.18%. And the 10-year Treasury bond yield fell 3 basis points to 2.58%. Gold fell $12.76 per ounce, or -1.04%.