Room to run

Since US stocks started their run nearly two years ago, the S&P 500 is up over 96 percent.  A move of that magnitude raises an important question: does this rally have legs or is it time to pull the plug?

This question came to the fore the other day during an interesting conversation with a good friend. He asked why he should bother investing in stocks since, he claimed, we are probably facing another "lost decade." After reiterating all my arguments about the futility of active investing and especially of making ten year forecasts, I found myself making the case for buying stocks now. I guess old habits die hard.

I have to admit I thought my arguments were pretty good, so I decided to share them with my readers. Please take the following ideas with a grain of salt. While I believe them, I also recognize my inability to see the future. Try as I might, that isn't a gift given to me.

I believe there are at least five distinct reasons why the current stock market rally has plenty of room to run.

1. Operating profits on the S&P 500 continue to advance rapidly.

As you can see in this chart, operating earnings have been in a powerful recovery since the third quarter of 2009, rising over 112%. At their current pace, operating earnings per share should reach record levels in the third quarter of this year. I often use operating earnings when I look at valuation because we want to gauge the core earning power of a corporation. Standard & Poor's defines operating earnings as income from the sale of goods and services excluding the effects of mergers, acquisitions, layoffs, recapitalizations, and other unusual items.

2. The ratio of price-to-operating earnings has room for moderate expansion.

At the time of this writing, the S&P 500 sits at 1332 reflecting a price-earnings ratio of 14.4 times forward 12 month earnings. To help put this in perspective, I looked at the frequency of various P/E levels for every quarter since 1988. As you can see in the chart, the S&P 500's P/E hovered most frequently in the 16 to 18x range. We could probably refine this even further by adjusting the analysis for different interest rate environments (i.e., P/E's tend to be higher during periods of low interest rates),  but that would only reinforce the conclusion suggested by this data--P/E's have room for moderate expansion.

3. Moderate expansion of P/Es will lead to large percentage gains in price.

P/E expansion is a powerful engine for market returns. This graph charts the level of the S&P 500 given different year-end P/E ratios assuming the market achieves the earnings levels currently forecast by analysts at Standard & Poor's. For example, with no P/E expansion for the rest of the year (i.e., the P/E stays at 14.4 times operating earnings)  and aggregate operating earnings exactly as forecast by Standard & Poor's, the S&P 500 index will end the year at 1385, about 4 percent higher than its current level. On the other hand, if the P/E expands to 17x by the end of the year, the index will end the year at 1635, almost 23 percent higher than it is today.

4. Dividend growth will help boost the market.

Dividend growth has lagged the growth in earnings, but that will likely change. Howard Silverblatt tracks dividend growth for Standard & Poor's. He sees four reasons why dividend growth is poised to accelerate:

  • Corporate profit growth has exploded.
  • Interest rates are low.
  • Corporations are holding record levels of cash.
  • Payout ratios are low while the ability to pay is high.

With these four factors in place, it will be hard for corporate directors to resist the pressure to pay out more of their cash as dividends to their shareholders.

5. Share buy-backs will increase.

The same pressures that drive corporations to raise dividends will push corporate directors to buy back stock. The result will be a clear bias toward higher earnings per share.

With all these factors working in our favor, I believe the current market rally will continue for the remainder of the year. For now, this rally certainly has room to run.