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Are stocks at their peak?

Are stocks at their peak?" /> Are stocks at their peak?" />
Record high prices in stock market indexes do not necessarily signal that stocks have hit their peak. In a Money Talk Video recorded Dec. 2, 2013, Bob Landaas and Brian Kilb discuss other considerations in determining the potential for stocks as investments. Here is a transcript of the video.

Brian: Bob, it’s been a great year for stocks. The S&P 500 is now up a little over 26%. The Nasdaq, a little bit higher. It’s funny after the last few years, people’s concerns about the lack of return, here we are with just a great year. People are starting to worry about the market being just a little bit overpriced.

Bob: Brian, particularly recently, the last seven weeks in a row, the stock market has set new highs every week. And the calls are starting to increase: “Bob, should we take some money off the table?” The market’s the highest it’s ever been. And I think it’s appropriate to put things in perspective.

First of all, stock markets never die at fair value. We’re trading for – give or take – about 15.5 times next year’s earnings. That’s about average. You look at some of the other measures: price-to-book, price-to-sales, price-to-cash flow – the stock market is either just a tad above average in terms of valuation or average. And markets die at excess.

When you see price-earnings ratios at 18, 19 or higher, and you see the other measures – price-to-book, price-to-sales, price-to-cash flow – at equally higher measures. As you know, we’re at fair value now. Markets don’t end then.

Brian: Well, that’s based on normal interest rates, as well, right? This is a very low interest rate environment. The stock market is a discounting mechanism. So when we look to future earnings, we want to discount those future earnings by an interest rate. Well, when the interest rate is especially low, as it is now, it allows for a higher price in the market place.

So comparing normal valuations in markets to historical norms as well, we really have some room to grow, based on just the lower interest-rate environment we’re in.

Bob: And then, Brian, throw in another variable of very, very low inflation. It argues for a period of low interest rates, perhaps longer than a lot of people are expecting.

Brian: And what about the earnings side? We’ve had great increase in annual returns in corporate America. It’s starting to flatten out a little as we look to the future but still projecting 7-8% increases in corporate earnings for next year.

Bob: And the year after. It’s all about interest rates and earnings. And you’ve spoken about low interest rates. What I think is so important for people to focus on is that 60% of the earnings for the S&P 500 come from outside the United States.

A client asked me this morning, “Gee, the unemployment rate is so high, how does that play out? That can’t be good for earnings.” And frankly, it doesn’t have that much of an impact when you think that less than 40% of the earnings for the S&P come from within the Unites States.

It matters, I think, structurally, but from a standpoint of stock market valuation, we care about the reliability, the dependability, the sustainability of earnings, and their capability to increase.

As you said, we’re looking at roughly a 7- 8% increase next year, and another 7-8% increase the year after next.

Brian: We have now had years of underestimating corporate earnings, and as we look ahead, and you and I start to talk about discounting future corporate earnings, we still have the opportunity to be surprised on the high side of earnings. So what will it take, Bob, to get corporate America to exceed expectations in corporate earnings and get those corporate earnings re-accelerating again?

Bob: One is revenue growth. You know, you can’t cut your way to prosperity. Brian, as you know, companies went on relentless cost-cutting campaigns over the last five years, and it’s showing up right on the bottom line.

Now, we’re finally seeing revenue growth, meaning you need to sell more of your product to do well. You just can’t keep cutting costs. And not only are we seeing revenue growth, but we’re also seeing more and more sectors of the economy participate in that revenue growth.

Now, folks need to be clear. Stocks correct, on average, 10% every year. We get a 20% sell-off, on average, every four years. It’s been a couple years now since we’ve had a 20% selloff. So the next one is not a matter of if, it’s coming. But when you look at the stock market, it’s clearly driven by earnings and interest rates, and on that count, they look pretty good for the next couple of years.

Brian: So, if stocks are fairly valued right now, what do we tell clients about what to do in terms of what to do in their portfolios these days?

Bob: I think stay balanced. You know, they have written extensively on the subject of building balanced portfolios, and stay with it. And I think the central point here, Brian, is that just because numerically the market is at an all-time high doesn’t mean that you lighten up on stocks. You really need to go deep on earnings and interest rates, and on that count, things look pretty good.

Bob Landaas is president of Landaas & Company.

Brian Kilb is executive vice president and chief operating officer at Landaas & Company.

Money Talk Video by Peter May
(initially posted Dec. 13, 2013)

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