Better than it feels

It's the rare holiday party where someone doesn't ask me THE QUESTION.

"So, what do you think the market will do next year?"

I admit I cringe at the question, because I really don't know. Still, since I know the question is inevitable, I have pulled together the following charts to help sort out my thoughts. I've divide the charts into three areas: U.S. economic performance, corporate earnings, and market valuation.

My conclusion is that the situation is better than it feels. Skittish investors would do well to bridle their fears and get busy with their long-term investment programs.

U.S. Economic Performance

As I've written in previous posts, the economy is doing better than it feels. Of course, high unemployment weighs on everyone. People without jobs worry about their futures, while those with jobs worry that they could be next.  But these anxious feelings do not negate the fact that the U.S. economy is beginning to make headway. Consider the following:

1. Retail sales have been better than expected.

Retail sales grew 0.8% in November and 1.7% in October.  Compared to last year, November sales were up 7.7%, the third straight month with year-over-year growth close to 8%. People may not be working, but they're still shopping!

2. Employment is improving.

Despite continuing high unemployment, we are starting to see a clear trend toward fewer and fewer unemployment claims. While job growth is well below the pace anybody would consider acceptable, we are starting to make progress.

3. Consumer confidence strengthens.

Consumer confidence--especially expectations for the future--is improving again. After the sharp rebound from it's lows in March 2009, the index has more than doubled.

4. Manufacturing expansion continues.

The Institute of Supply Chain Management ISM) surveys its members monthly as to their activity level and outlook. The percentage of those indicating improvement is reported with a number greater than 50 indicating expansion. As you can see in the accompanying chart, the expansion in manufacturing started at the end of 2009 and has continued through today. We are now at levels well above those immediately preceding the debt crisis.

Corporate earnings

These two pie charts show the percentage of S&P 500 companies reporting sales and earnings that beat, missed or met analyst's estimates in the third quarter. For every company that missed estimates, there were two other that met or exceeded expectations. It is worth noting the strength in sales. In the early days of this recovery several analysts complained publicly that strong corporate profits were being driven by draconian cost cutting. The mantra at the time was that cost cutting could only go so far. We now appear to have turned a corner where profits are coming not just from sound expense management, but also revenue expansion--a powerful combination.

Equity Market Valuation

The S&P 500 is now trading at a price to earnings ratio of about 15.5, a remarkably low level. When estimated operating earnings for 2011 are fully factored into picture, however, the ratio drops to just over 13, the lowest level since the late 1980's. The U.S. equity market is clearly cheap to recent history. Pundits can debate the issues all they want, but the fact remains, we haven't seen stocks this cheap in a generation.

Conclusion

Based on the evidence, I expect that 2011 will be a decent year in the U.S. equity market. The economy continues to slowly recover from the trauma of the debt crisis, companies continue to beat investor expectations, and stocks are trading at valuations we haven't seen in in almost 20 years. Despite the very real difficulties we face, I couldn't imagine a better time to buy stock.

Now, having said this, I want to reiterate that I do not endorse trying to time the market. I have written many other articles showing in clear terms that efforts to beat the market are ill-conceived. Instead, the evidence is overwhelming that an investor is much better served by holding with a disciplined strategy designed to fit her unique situation. That said, if anxiety about the economy or corporate earnings or stock market valuations have kept you sidelined, now would be a good time to set aside your fears and implement your strategy.