STOCKS CLIMBED TO THEIR highest levels in 26 months, with the Dow Jones Industrial Average reaching its highest peak since Lehman Brothers’ collapse set off a world-wide financial crisis. Now what could possibly Sherpa stocks higher?
Last week’s 3.6% gain was delivered on the backs of two long-anticipated events: Republicans seized control of Congress in the midterm elections, and the Federal Reserve said it will pump $600 billion into our economy, by buying roughly $75 billion worth of Treasury securities per month through next June. It also helped that manufacturing activity expanded in October and the U.S. economy added 151,000 new jobs, the best showing since April.
Several catalysts are needed to extend that high, the first of which involves tax policy. “With 36 different tax programs set to expire on Jan. 1, some clarity is needed on any potential extensions of part or all of the tax cuts,” notes a well known Wall Street strategist. Traders are already counting on an extension, and this strategist’s call for 2.2% economic growth next year, for example, could be slashed by half if the Bush tax cuts were allowed to expire.
Also, “confidence remains more subdued than it could be, especially as way too many Americans believe that the country is headed in the wrong direction,” he adds. A persuasive plan to cut our deficit and chip away at the government’s ballooning debt burden might surprise skeptics and could help restore economic confidence in the long run. The president’s commission for deficit reduction will report on Dec. 1.
Meanwhile, corporate America must squeeze greater earning power from today’s hospitable interest rates. Standard & Poor’s 500 companies are on track to earn a weighted average of $85 a share in 2010, according to Thomson Reuters. While analysts’ projections for earnings to grow 13% next year to $96 seem rather optimistic, it will take a mere 4% improvement to surpass the previous peak in profitability, when companies earned $88.18 in 2006.
If today’s leaner, meaner companies merely matched their 2006 prowess and earn $88 a share next year, the stock market would be valued at 13.9 times future profits. Only once in the past two decades has the S&P ended a year with a price-to-earnings multiple of less than 14, notes BofA Merrill Lynch strategist David Bianco. That was in 1994, when the Fed was hiking rates and the 10-year Treasury yield was pushing 8%. Today, the Fed is hell-bent on keeping rates low, and the 10-year yield is slumping at 2.5%. Bianco sees S&P profits topping $90 next year and thinks “there’s room for stocks to rally on the earnings outlook alone.”
Of course, valuation multiples and public confidence are so low because our government is burdened with debt, and investors are rightly concerned that much-needed austerity measures will crimp profits in future. That’s why this uncomfortable rally was populated largely by performance-chasing professionals, and even as stocks rose 17% over the past 10 weeks, individual investors yanked more than $39 billion from U.S. stock funds and plowed $83 billion toward bond funds.
The S&P 500 is now 21.7% below its 2007 peak. To close that gap, more investors must believe that stocks offer a viable–or at least cheap—hedge against the inflation that must eventually follow the Fed’s frenzied money printing. As the dollar slid further last week, crude oil and copper rose to 2010 highs, and gold closed in on $1,400 a troy ounce, a record.
The Dow ended the week up 326, or 2.9%, at 11,444. The S&P 500 rallied for a fifth straight week and snagged its ninth gain in 10 weeks. That’s its highest finish since Sept. 19, 2008, and the benchmark is up 9.9% this year. The Nasdaq Composite Index added 72, or 2.9%, to 2579, while the Russell 2000 jumped 33, or 4.7%, to 737 (Source: Barrons Online).