The past five years in the stock market have been a wild ride. The S&P 500 lost about half of its value from high to low only to rebound by over 130% in the past three and a half years.
Many investors were unwilling to accept such high volatility and migrated from stocks to bonds. Today with the market near record levels, many investors are:
1. Underinvested in equities,
2. Overinvested in low yielding bonds and exposed to risks associated with rising rates and inflation,
3. In need larger portfolio returns to properly fund their retirements, and
4. Uncertain about how to modify their current investment positioning for the next five years.
This past week, we spent some time thinking about the bull case for stocks. With stocks at highs, it is relatively easy to make the case for why stocks might trend lower. This is what they did in 2000 and 2007. While it is somewhat uncomfortable for many investors to be fully invested in equities when the market is near record levels, the bull case looks stronger to us currently than does the bear case.
We expect stocks will continue to trend higher over the next several years. In fact, we believe they may double again from today’s prices.
The Bullish Case for the Stock Market
Stocks are inexpensive.
The current price/earnings multiple of stock continues to be well below the average of 17.8x since 1950. (Note: Chart shows forward rather than current historic average P/E and is dated since 1994). The discount to historic value is even more extreme when you consider interest rates are near historic lows. Over the past 60+ years, the average P/E of the market has been nearly 22x when interest rates are below 2.5%.
Analysts forecast S&P 500 earnings will be about $136 in 2015. On a normalized P/E ratio, the S&P 500 would be trading at close to 3,000, nearly double its current level.
Low interest rates are here to stay.
Low interest rates are like a turbo boost for stock prices. Since 1950, stocks have had an average annual return of about 7%. When interest rates and inflation are low, the average annual return on stocks has been roughly 13%.
The Federal Reserve has made clear it will not raise rates “as long as inflation is not forecast to rise more than 2.5% in the future and as long as unemployment remains above 6.5%.” These conditions are unlikely to change until at least 2015.
Since 1994, stock yields (inverse of the forward P/E) have never been more attractive relative to bond yields.
Money flows have turned and are now flooding into stocks.
In the first five weeks of 2013, $25 billion flowed into stock mutual funds. This is the biggest inflow in any five-week period since April 2000. As stocks continue to rise and bonds offer zero to negative returns, equity in-flows will only increase. After the longest period in modern market history of stock market outflows, the in-flow cycle could be particularly powerful and last for years.
The World is Becoming More Equity Friendly.
Risks are abating. The consumer is de-levering. House prices are rising. The U.S. economy is expanding. The federal government has begun the process of slowing deficit expansion. European banks and the euro currency have been backstopped by the European Central Bank. China economic expansion is back on track. In short, the world is becoming more equity investment-friendly day-by-day.
The corporate credit market is booming.
Corporations are raising a record amount of capital at record low rates. They are holding approximately $1.4 trillion in cash. Much of this cash is being used to buy stocks in corporate equity buybacks and mergers and acquisitions. Balance sheets have never been stronger and corporations have returned to investing for earnings growth.
Many of the points above have been true for the past four years. The market has appreciated by 130% from the lows. What stands out most at this time is how much more stable the investment environment has become and how financially strong American corporations are. Additionally, many investors remain anxious and skeptical which allows the stock market to climb the “wall of worry.”
For us, our option trades will continue to be biased towards calls. Outside of options, we will have an equity focus tied to a tactical discipline which will systematically reduce our equity exposure in the event stocks enter a major down trend.
Review of Positions
Charles Schwab (SCHW) – On Mar 7, we recommended to buy to open the SCHW Sep 18 Calls (SCHW130921C000018000) for $1.05 or less. As of Friday’s close, these options closed at $1.03.
TD Ameritrade (AMTD) – On Mar 8, we recommended to sell to close the AMTD Aug 22 Calls (AMTD 130817C000022000) for $0.90 or more. We bought this position on Mar 1 for $0.40 making this a 125% winner in a week.
EMC (EMC) – On Jan. 10, we recommended to buy to open the EMC April 25 calls (EMC 130420C000025000) for $0.95 or less. As of Friday’s close, these options closed at $0.43.
Healthcare Trust of America (HTA) – on Feb 13, we recommended you buy to open the HTA Jul 12.5 calls (HTA 130720C0000125000) for $0.45 or better. On Friday, this position closed at $0.45.
Lilly (Eli) & Co. (LLY) – On Jan. 9, we recommended to buy to open the LLY July 55 calls (LLY 130720C000055000) for $1.45 or less. As of Friday’s close, these options closed at $2.06.
Thomson Reuters (TRI) – On Jan 16, we opened a position in the TRI Jul 30 calls (TRI 130720C000030000) for $1.60 or less. As of Friday’s close, this position was $1.70. We continue to like this trade.
Parting Shot: Market Sentiment Indicator
Shown below is our MSI (blue line) superimposed on the equal weighted S&P 500 measured by the ETF (RSP). We are bullish on the stock market when the MSI is above the 50% market and bearish when it is below.
The scale for the MSI is on the left hand y-axis. The MSI has declined from 74.1% to 73.2% through Wednesday of last week but has since turned higher. The market remains bullish in the intermediate term and is not showing signs of being significantly overbought.
We remain bullish.
Have a great week trading,
Nick Atkeson and Andrew Houghton
Big Money Options