Seven Reasons Not To Give Up on Stocks

With market averages trading at all-time highs, deciding whether to reduce or eliminate stock positions has become a favorite topic among investors.

 
A market correction after nine months of strong performance would not be unprecedented. Markets rarely move in one direction all the time, and so it should not come as a surprise if the stocks retrace some of their recent gains in the weeks ahead.

That said, in my opinion, I would not be changing stock commitments at this point, unless there will be a need for funds in the near future.

Many are worried that the global economies may slow as we head towards the second half of 2013.  However, as I discuss below, the direction of markets and the economy can often diverge markedly.

In addition, given the dismal track record of the economics profession over the past few years, I would be hesitant to make investment decisions based on any economic forecasts.

As I have listened to analysts and company managements over the past few months, most indicate that while sales trends are not necessarily robust,  business continues to show modest growth.

More importantly, from an investor's standpoint, corporate managements are keeping a close watch on the expense side, and should be able to maintain today's robust operating margins.  If this is the case, many will probably be able to grow earnings in 2013 in the mid to high single percentage range.

Finally, serious bear markets are typically preceded by tightening credit conditions, and there is little evidence of any unease in the bond markets today.

Here are my seven reasons to stick with stocks:

1. Central Banks Want You to Take Risk - Keeping interest rates near 0% makes it painful to hold cash reserves. Federal Reserve policy will likely remain accomodative for at least another couple of more years, as will the Bank of Japan and the European Central Bank.;

2. Stocks ≠ the Economy - Stocks can do well even if the economy struggles. Strategist Ned Davis looked at data going back to 1948, and found the correlation coefficient between nominal GDP and the S&P 500 is just 0.13.  Put another way, changes in GDP explain less than 2% of the year-to-year variation in stock prices;

3. Stocks Are Cheap Relative to Bonds -  The earnings yield of U.S. stocks is at their lowest valuation relative to bonds since 1980.  The dividend yield of the S&P 500 is 2.1%, compared to a 1.9% yield for the 10-year U.S. Treasury note; the last time stocks yielded more than bonds was in the 1950's. Stocks are not without risk, but they at least offer the best chance of earning positive real returns in the years ahead;

4. Investors ♥ Bonds - Bonds continue to be the investment of choice for many despite negative real (i.e. inflation-adjusted) yields. Individuals may have added almost $20 billion to U.S. stock funds this year, but this amount is only 3.5% of the withdrawals since 2007. Bond funds, meanwhile, have seen a $44 billion inflow so far in 2013, even with rates at historic lows. As investors become less focused on the 2008 bear market, and more aware of the meager bond returns they are earning, we are likely to see a significant rotation from bonds to stocks;

5. This Isn't 2008 - The S&P 500 is about +10% higher than where it stood 5 years ago, yet corporate profits are +50% greater. Corporate America has continued to prosper, but the market's valuations have not kept pace. Also, unlike 2008, credit markets do not show any signs of financial stress;

6. Corporate Cash Balances  - Corporations have stashed away more than $2 trillion in cash reserves. Managements will be under considerable pressure to deploy some of their hoard either in the form of share buybacks; dividends; or M&A activity. All three of these decisions would be favorable for stocks;

7. Pension Funds Are Underinvested In Stocks - Pension fund allocation toward equities has gone from 60% in 2005 to 38% today.  Meanwhile, allocation to fixed income has gone from 27% to 41%, despite the fact that most bonds do not offer rates anywhere close to assumed actuarial rates.  Eventually there will have to be some reallocation.

Wall Street estimates for the S&P 500 are for earnings to reach around $112 in 2013.  If you put a 14.5x price/earnings multiple on this figure (or about where we are trading now), you come up with a year-end value for the S&P 500 of around 1600, which is probably not a bad "guesstimate".