Market Rally Strong, But Participation Weak

108.4 … No, that is not the region’s newest FM station, nor is it the average high temperature for the month of June in Phoenix (although it is close). Rather, that figure is the return on the S&P 500 stock index from March 6, 2009, through April 29, 2011: 108.45%. Annualize it, and it comes to a 40.77% return per year.

However, the most interesting part of the stock market rally isn’t the numbers, but rather the lack of participation in the stock markets. Throughout most of the past 25 months, investors have chosen to put very little new money into the market, foregoing one of the strongest two-year rallies in recent generations. After enduring two major market selloffs within a decade, many found themselves so traumatized and financially hurt that the thought of putting new money to work in what appeared to be a casino-based marketplace was simply beyond their acceptance. This is why we always need to remind ourselves that investing is a journey that never ends; only the goals, objectives and investment paths change. Because investing is a process of evolution, we must remain engaged if we are to expect any chance of success.

Stock Market Skepticism
There will always be a wall of worry in the market. Think back to a year ago, when the world was watching the European Union struggle with the debt crisis and bailouts of several sovereign nations. On May 6, 2010, we were left wondering what caused the market “flash crash,” with the Dow Jones Industrials “mysteriously” falling by 700 points in just 11 minutes. Goldman Sachs’ traders had shown a profit at their internal trading desk every day of the previous quarter, while seven of the nine top-recommended trades for their clients were losing trades. It is no wonder skepticism abounds. Still, the fundamentals of the economy will always prevail—as shown by the 108% market rally, supported over the past two years by improving economic growth, employment, productivity and record corporate profits.

S&P 500 Update
2011 is shaping up to deliver the highest earnings per share for the S&P 500 in history. Cash on corporations’ balance sheets is sizable, and we are seeing companies put the funds to work through renewed merger and acquisition activity, increased dividends to shareholders, and expanded research and development to enhance future growth. Even with the significant rally we’ve experienced, we do not see the current market environment as being overvalued, given the strong earnings growth and economic trends. Currently, the S&P 500 is trading at 15.4 times trailing 12-month earnings and 13.9 times estimated earnings. To put things in perspective, over the last 30 years, the average price-to-earnings ratio (P/E) of the market has been 18. Over the last 20 years, it has averaged 20, and in the last 10 years, it has averaged 17.7. From that simple comparison, it would appear the current market is undervalued. Valuations are even more compelling when viewed from the perspective of other investment opportunities, particularly fixed income.

10-year U.S. Treasury Bond
Yields on the 10-year U.S. Treasury bond were at 3.29% on May 11, 2011. If an investor were to purchase this bond and hold it in a taxable account, taking into consideration the eroding effects of inflation at 2.7%, the investor’s real return after taxes and inflation would be less than 0.00%. That’s right—not only is there no real return, but the return is negative by approximately -0.25%. Sometimes it is helpful to view the valuation of the equity market relative to the fixed income market by comparing the earnings yield on the stock market with the yield of the 10-year Treasury. The stock market earnings yield is derived by taking the inverse of the price/earnings ratio and viewing it from the earnings/price perspective. On that basis, the earnings yield of the S&P 500 is 6.5%, well ahead of the current 10-year bond yield of 3.29%. One could argue that the Federal Reserve’s action to manipulate interest rates has a distorting effect, and that the natural, market-based yield should actually be higher. We would agree with that position; however, the distortion appears to be on the order of 50 to 100 basis points. Even if we add 0.5% to 1% on top of the current 3.29% yield to compensate for the distortion, the earnings yield of the equity market would continue to indicate that equities remain attractive relative to bonds.

An example is Bell State Bank & Trust’s SBT Equity Income strategy, in which we build a tailored portfolio consist¬ing of approximately 85% common stock, coupled with a mix of preferred stock and real estate; this strategy is currently delivering a dividend yield of 5.19—57% higher than the yield on the 10-year U.S. Treasury bond. This strategy combines the benefits of strong cash flow with growth potential and is one of several tools we use to help our clients balance the inherent market risk with the desire for acceptable income.

Yes, there will always be a wall of worry to climb. Today, the greatest causes for concern are the U.S. debt ceiling, the end of the Federal Reserve’s quantitative easing programs, conflict in Libya, European debt, economic impact of the Japanese tsunami and radiation leak, and the risk of stagflation. Tomorrow’s “black swan” events are unknown. We do know that investors have short- and long-term goals, and that the only real chance of achieving them is to be engaged in the capital markets. This engagement must balance today’s risks and valuations with tomorrow’s threats and opportunities.

Bell State Bank & Trust’s investment professionals use a broad range of investment strategies and products to meet our clients’ goals. By strategically implementing traditional investments via bonds and stocks, along with alterative investments encompassing commodities, currencies, real estate, precious metals, gold, and silver, we are prepared to move beyond the wall of worry while recognizing the challenges that will always be present.

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