Both the 2010 and 2011 spring swoons were besieged by widespread fears of an imminent calamity in the euro zone and by a hard economic landing among emerging economies. While these fears still linger today and will continue to flare periodically, they appear to have lost much of their intensity. Indeed, there is a growing sense that although euro-zone problems will persist for many years, the “crisis” may have passed and also a growing appreciation that recent increasingly aggressive policy actions by emerging officials will likely succeed.
Stock Market Valuations Much Improved and Investor Sentiment is more Bearish
As illustrated by Charts 8 and 9, despite its recent new recovery high, the stock market is much more attractively priced today compared to either the spring of 2010 or the spring of 2011. Its cheaper current valuation, both on an absolute basis and relative to bonds, makes the stock market much less vulnerable to a serious swoon.
In April 2010, the S&P 500 price-earnings (PE) multiple was above 18 times trailing 12-month earnings and the 10-year Treasury bond yield reached almost 4 percent. Similarly, in early 2011, the S&P 500 PE multiple reached almost 16 times while the 10-year yield was still above 3.5 percent. Today, the S&P 500 trades at a PE multiple of only about 14 and the bond yield has collapsed and remains less than 2 percent!
While many believe investors are much more confident today and think investor sentiment is simply too bullish, as it was in 2010 and 2011, these valuations charts suggest otherwise. In 2010, confidence among stock market investors was illustrated by a willingness to pay 18 times earnings while bond investors demanded almost a 4 percent yield. Today, by contrast, stock investors are only willing to pay 14 times even though bond investors are content in accepting less than 2 percent yields. At least compared to either 2010 or 2011, the stock market seems much more cheaply priced and investor sentiment seems much less exuberant.
Summary
Both the stock market and the economy have hit a soft patch in recent weeks. Even weaker economic momentum and a deeper retrenchment in stock prices could still be forthcoming. In the short run, who knows?
However, widespread fears this spring will prove another replay of the last two years when a significant economic stall precipitated a major decline in the stock market appear overblown. Economic policies about the globe are far more accommodative today, the economic recovery illustrates a much more mature character, U.S. household fundamentals are much healthier, euro-zone issues have perhaps been successfully transformed from an imminent calamity to simply a chronic problem, hard landing scenarios in the emerging world seem increasingly likely to resolve into reaccelerating emerging recoveries, investor sentiment remains fairly cautious, and the stock market is much cheaper today.
Although the path will certainly be uncertain and volatile, we continue to expect U.S. real GDP growth of about 3 percent this year, for the S&P 500 Index to surpass the 1500 level, and for the 10-year Treasury yield to rise to between 3 to 3.5 percent by year end. We recommend investors curtail exposure to high quality bond investments and stay overweight towards the stock market where we currently favor emerging markets, industrials, materials, and financials.
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