Even after a seven-year bull market in U.S. stocks, investors are still skittish. Here are five indicators that suggest stock prices may move even higher.
Global equities have performed exceptionally well since the February lows. However, we at Morgan Stanley Wealth Management think there is more upside potential as investors begin to appreciate the rate of change improvement in the economy, and importantly, corporate earnings. Still, due to the extraordinary political environment in which we find ourselves, investors remain more skeptical and bearish than normal. This should help to fuel higher prices later this year.
One of our out-of-consensus calls this year has been our belief that the global economy experienced a harsh recession last year. This recession was driven by the collapse in oil prices and the extremely negative knock-on effects that had on the energy, materials and industrial complexes. What’s more, China and many of the emerging markets leveraged to commodities were disproportionately affected. The chart below shows just how severe that recession was when measured in U.S. dollars. In fact, it was almost as severe as the recession we experienced in 2008-2009. The recession’s trough was actually in last year’s third quarter, and growth has been recovering ever since. Importantly, Morgan Stanley’s Global Trade Leading Indicator suggests this recovery will continue. The pickup in growth is supportive for global equities and why stocks have done exceptionally well since February.
If there is one thing that has driven stocks more than any other, it’s earnings. Due to the global economic slowdown last year and the very strong U.S. dollar and Chinese yuan, we experienced a significant earnings recession for the S&P 500 and other major global equity markets. In fact, the earnings decline since 2014 has been one of the most severe witnessed in the past 20 years. Because the economic slowdown was concentrated in the energy, materials and industrial complexes, the decline in earnings was more concentrated in those sectors as well. We trace the breadth of earnings-estimate revisions as a leading indicator of earnings growth, and the chart below clearly illustrates revisions have troughed for the four major equity market regions. This should bode well for the equity prices of these regions as well.
Stock markets themselves are often their own best leading indicator of future prices. One variable we track closely in this regard is market breadth, a measure of a stock market’s underlying health. Just as a person who “looks good” can be unhealthy, a stock market that is rising but with fewer and fewer stocks participating can be troublesome. The good news is that this year’s rally has been marked by much stronger breadth. In fact, in the S&P 500 Cumulative Advance-Decline Line seen below—a calculation of the number of stocks advancing less the number in decline—shows that, while cumulative breadth over the past few years has been flat (purple area), this year it has broken to all-time highs. This is an important development that supports our conviction in the new highs generated by the S&P 500. In other words, the strong breadth suggests prices can continue to move higher, much like we experienced in 2013.
One of the most common questions we get from advisors and clients is about valuation. Many are worried that price/earnings multiples are higher than we have seen 70% to 80% of the time. However, such an observation does not adjust for record-low interest rates and borrowing costs for the average company. When we make that adjustment, stocks not only look reasonable but downright cheap. The chart below shows the forward consensus earnings estimate for the S&P 500 divided by the current average borrowing rate for an S&P 500 company. Based on this measure of “fair value,” the S&P 500 appears to be 20%-to-25% undervalued. If we performed the same exercise on the emerging, European or Japanese equity markets, the undervaluation is even greater.
*Fair value is 12-month forward consensus earnings estimate divided by the Moody’s Baa corporate bond interest rate
Even after a raging seven-year bull market in U.S. stocks, investors are skittish. Whether it’s the scar tissue left behind from the financial crisis and the tech bubble or a fear of the unknown from unprecedented monetary policy, caustic political rhetoric and persistent terror events, it is not clear. However, when looking at the exceptionally negative money flows out of equity funds in the past few years, there is no denying that sentiment is bearish. To put this in context, the flows out of U.S. equity mutual funds and exchange-traded funds in the past 18 months have exceeded the cumulative outflows between 2008 and 2012, the wake of the financial crisis. To say that this is the most unloved bull market ever would not be a stretch, and this is not how bull markets usually end.
Year 2000 flow is mutual fund only
2016 is -$42 Billion as of May 31, 2016. Annualized figure is -$102 Billion