With the end of a pretty exciting quarter for equities just behind us, what does the future hold? Here's my simplistic view, which remains optimistic because I continue to see signs that tell me the market remains pessimistic.
As the chart above suggests, the S&P 500 is currently right about in the middle of its long-term upward trend. The 6.8% annualized trend lines that I've drawn translate into a total return of over 8% a year when you included reinvested dividends, and this trend is consistent with the 11.1% annualized total return of the S&P 500 since the end of 1949. The existence of many trillions of dollars "sitting on the sidelines" in the form of cash and cash equivalents that pay almost nothing, while stocks have reaffirmed their ability to move higher over time by at least 6.8% a year, is a good indicator that the market as a whole has very little confidence in the long-term outlook.
As of the end of March, the trailing 12-month PE ratio of the S&P 500 was 14.56, which is about 12% below its 52-year average. No sign of excessive optimism here: in fact, since reaching a peak of 30 in June 1999, multiples have fallen by more than half while after-tax corporate profits (as calculated by the National Income and Product Accounts) have surged some 160%. This is a market that holds out no hope that profits will do anything but languish and/or decline in the years to come.
Another way of looking at profits is to compare the earnings yield on stocks (the inverse of the PE ratio) with the yield on corporate bonds. The first of the two charts above uses the average yield on long-term BAA-rated corporate bonds as a proxy for yield on the typical corporate bond. Here we see that earnings yields are still substantially higher than bond yields, a condition that has been relatively rare over the past 52 years. When the market is very confident in the ability of earnings to rise over time, as it was from the early 1980s through the early 2000s, earnings yields were consistently below the yield on corporate bonds, because investors were willing to forego a portion of the relative safety of bond yields in order to capture the expected price appreciation of equities.
The second of the two charts above compares the earnings yield on stocks to the yield on 10-yr Treasury bonds. When Treasury yields are higher than equity yields, it's a good sign that the market is distrustful of the ability of earnings to grow. "Distrustful" is a rather timid description of investors' outlook today, since the market is essentially indifferent to earning 2.2% on risk-free bonds while stocks are offering 6.9%. That spread of 4.7% today is much wider than the 3.2% recorded at the market's bottom in early March 2009, and only moderately tighter than the all-time high of 6.2% recorded late last September. In short, the sizable gap between the current yield on equities and the yield on risk-free Treasuries reflects a very pessimistic outlook embedded in current prices.
Of course, the market may well be correct in its belief that the outlook for the economy and corporate profits is miserable. But everything I see tells me that the economy continues to grow, albeit relatively quite slowly given the depths of the recent recession. The story of the equity rally to date is one of stocks moving higher because the reality has continually proved to be less awful than the expectations, and I think this will continue to be the case for the foreseeable future.