Every day, it seems like the markets are making new highs. Hyper-growth tech darlings like Facebook Inc (NASDAQ:FB) and Amazon.com, Inc. (NASDAQ:AMZN) continue to power the NASDAQ-100 to new highs. Meanwhile, traditional giants like Wal-Mart Stores Inc (NYSE:WMT) and McDonald’s Corporation (NYSE:MCD) are finding their groove again and pushing the Dow Jones Industrial Average to all-time highs.
But this bull market is not without its doubters. In fact, many bears claim that this market has “bubble” written all over it.
Just look at valuations. The cyclically adjusted price-to-earnings ratio, a valuation measure which smooths out for inflation and other noise, is above 30. It’s only been there twice before, before the big crash in 1929 and during the dot-com bubble in the late 1990s and early 2000s.
But valuation has been rich for a while. The CAPE ratio has been above 30 since August. Since then, the S&P 500 is up 4% while the Dow Jones today is up nearly 6.5%.
So is this market due to snap back like a rubber band? Or does this stock market rally still have legs?
Given the recent rallies, strong earnings, positive economic data and potential tax reform, I think it’s the latter.
First and foremost, it’s worth noting that this market been richly valued by historical standards for some time. Historically, the average CAPE ratio has hovered around 17. The market has traded north of that CAPE ratio since 2010, so this is a seven-year bull run with an ever-expanding, above-average valuation.
A big part of this is low interest rates. From 1980 to 2007, the 10-year treasury yield hovered (on average) around 7.5%. The S&P 500 earnings yield hovered around 6.3% in that time frame. In other words, the 10-year treasury yield was about 120 basis points above the S&P 500 earnings yield.
That isn’t the case today. Although the earnings yield today is far below its historical average (3.9% versus 1980-2007 average of 6.3%), it is actually 150 basis points above the 10-year treasury yield (2.4%). Until these two sit on top of one another, stocks should be able to go higher. And because interest rates could be low for a lot longer thanks to technology and automation, I think this bull run in the stock market will last for a while.
Secondly, the economy is finally breaking out of its slow-growth monotony. Despite hurricanes ravaging certain cities last quarter, the U.S. economy still grew 3%. That follows 3.1% last quarter. The U.S. economy has now recorded its best six-month growth stretch in three years.
Granted, this economic growth would traditionally force interest rates higher and offset the low-rate tailwind. But largely due to technology and automation, core inflation remains soft while incomes remain stagnant. Thus, the outlook for the economy is robust growth on low rates. That implies higher stock prices in the future.
Thirdly, the U.S. economy is growing at a 3% clip even without any tax reform. Congress recently approved a joint budget resolution, and that paves the path for tax reform by next year. Any cuts in the corporate tax rate would boost earnings estimates and make currently stretched valuations seem a lot more reasonable.
Fourthly, earnings are really, really strong. The third quarter has been really good for the S&P 500. Companies are beating earnings in greater frequency. According to FactSet, about 76% of companies that have reported so far have topped earnings expectations versus a five-year average of 69%. Same thing is happening with revenues. About 67% of companies that have reported so far have topped revenue expectations versus a five-year average of 55%.
And the beats are of greater magnitude, too. Earnings are topping estimates by about 4.7% versus a five-year average of 4.2%. Revenues are topping estimates by about 1.5% versus a five-year average of 0.5%.
All in, then, the stock market doesn’t look overheated here. Yes, stocks are ripe for a pullback since there hasn’t been one of any serious magnitude in ages. Yes, valuations look silly if you don’t consider the growth backdrop.
But the growth backdrop is pretty strong. Companies are topping earnings and revenue expectations in greater frequency than before, and the beats are bigger than normal. The U.S. economy just recorded its strongest six-month stretch of growth in three years. Tax reform is coming. Interest rates are low.
I’m bullish on the stock market. I think a pullback of 5-10% would be healthy, and I think any such pullback would be a tremendous “buy the dip” opportunity.
As of this writing, Luke Lango was long FB, AMZN, and MCD.