4 Reasons Why Stocks are Ready to Make New Highs

farshine

4 Reasons Why Stocks are Ready to Make New Highs
By: Steve Reitmeister
February 19, 2011

In the summer of 2010, investors became obsessed with the idea of a double dip recession. With that the market pressed down to Dow 10,000 with many experts looking for a lot more losses to come. From that darkest hour we have emerged with an impressive 20%+ rally lasting over six months.

Now the question on everyone's mind is: What's next for the stock market?

I strongly believe the answer is that we are due for more gains. Not just because there is no double dip. More importantly, there are sound fundamental reasons for the market to continue its advance. Here are 4 such reasons.

1) Corporate Earnings

We just came through another strong earnings season. And the simple fact is that the health of corporate earnings has more to do with the movement of stock prices than any other measure. (If this is news to you, then perhaps you forgot that buying stocks is about buying an ownership stake in a company. And owners of companies don't care about the "chart pattern" of the stock price. They care about the stream of earnings they will receive in the future.)

So how good was Q4 earnings season, you ask? Here are the results for the S&P 500 stocks:

    * 3.42 stocks had a positive surprise for every 1 that was negative
    * 1.88 positive estimate revisions ratio. Meaning estimates are moving up for the future
    * Year over year growth of +43.7%


2) Valuation

Thanks to the strong earnings noted above, the bottoms up estimate for the S&P 500 this year currently stands at $96.04. Which means that the S&P is only trading at a PE of 13.9X current estimates. That is very reasonable by historical standards.

Now consider the earnings yield of stocks, which is dividing the $96.04 in earnings by the current S&P price level. That comes out to 7.2%, which is VERY attractive compared to the meager 3.6% yield on the 10 year Treasury. This last point has been a big driving force behind the rally in stocks that takes us to where we are today. And as you can see, there is plenty of room for it to reach higher valuations without being considered too pricey.

Lastly, you need to remember that we have enjoyed a string of several quarters in a row where Corporate America had sparkling earnings, which lead to higher estimates. So it is quite likely that by the end of 2011 the actual earnings may be more like $100+ instead of the current view of $96, and thus the market will rise that much more to reach fair valuation.

3) End of the Bond Rally

The 30 year bond rally ended in October 2010. The initial move higher was simply a reflexive bounce from obscenely low levels induced by all the double dip fears that drove people to the safety of bond investments. But now there are much bigger reasons for rates to go higher. And that is inflation.

Back in 2002, before he was Fed chairman, Ben Bernanke said that any outcome is better than deflation. So he outlined all the ways in which the Fed can fend off deflation by creating inflation. His methods were akin to throwing trillions of dollars out of a helicopter to the people below...and since that day many still call him Helicopter Ben.

It is clear that the Fed under Bernanke's direction will fight deflation with every ounce of their energy. The most likely outcome is inflation, and we can already see signs of it in our midst (check your recent food and gas bills to see it on the rise).

Higher inflation = higher bond rates = investors losing money in bonds = more money flowing out of bonds into the stock market for attractive returns. This equation is already in play with more momentum to come.

4) Individual Investors Ready to Get Back In

Survey after survey shows that the average individual investor has been scared out of the stock market given the precipitous drop after the Financial Crisis. Then toss in last year's tremendous volatility and you can understand why they've been saying "no thanks" to stocks for a while. But given human nature, they won't stay away for long.

Now that the market has pushed to new highs, the media is starting to make a big deal about the stock market once again. The more this message gets out there, the more individual investors will feel they are missing out. As they pile back into stocks it will fuel the rally higher, which will pull even more investors back into the market.

How high can the market get? Given the valuation scenarios I shared above, we can easily make it to Dow 13,000 without being overstretched. And if the pendulum starts to swing away from fear and back to greed, it could go above that level over the next 12-18 months.

What to Do Next?

On the surface I know it sounds like I am saying to just buy any stock and you will profit from this rally. Certainly the rising tide usually lifts all boats...but some boats do a lot better than others.

First, you need to focus on companies exceeding earnings expectations each quarter, which leads to higher estimates from analysts. This in turn leads to higher investor interest and a higher share price.

Second, keep an eye on valuations. Yes, I noted earlier that the overall market was reasonably priced. However, each week I go looking for new stocks I am noticing that more and more are overpriced. So only select those stocks that are trading at discounts to peers

longzhang