Stocks are now getting richly valued. And delivering the earnings needed to keep the rally going may require strong economic growth ahead. Given the serious problems the economy still faces, however, that's a risky proposition.
The S&P 500 rallied 1.2% to 1108 on Tuesday while the Dow Jones Industrials posted a 126-point gain to close at 10471. Since March, both indexes are up more than 50%.
At current levels, the S&P 500 now trades a little above its historical average of 15 times the next year's operating income. To deliver on that, corporate earnings will have to grow by a sharp 33%. This bar is lower than it may seem at first glance because of the massive losses that many companies and the banking sector in particular racked up last year.
But it would still require earnings to expand 9.4 times faster than even the upper end of the Federal Reserves' recently boosted growth estimates -- between 2.5% to 3.5% -- for U.S. GDP in the year ahead. That's well above the usual ratio of earnings growing 6.1 times faster than GDP. The U.S. economy would have to come roaring back at a 5.4% rate to bring the ratio back in sync with historical averages.
Choppy Economic Signals
Of course, some factors could help this time around. S&P 500 companies now rely on overseas markets for half their revenue. Some emerging markets like India are showing signs of strong growth, and that could help offset the drag from a lackluster U.S. And some high-profile investors have argued that the downturn's severity is the best indicator of the strength of a rebound -- implying that even an 8% expansion could be in store.
Recent signals about what an economic recovery might look like, though, are very choppy. The manufacturing sector continues to expand, and home sales are picking up. But unemployment is now widely expected to remain sky high as the small businesses that provide the bulk of American jobs are still in the midst of a brutal credit crunch. And the Federal Reserve has recalculated its initial estimates of a 3.5% GDP expansion over the last quarter to a much less impressive 2.8%.
While most likely not in the midst of an obvious bubble like some bears have argued, stocks do seem priced for a very rosy scenario in the year ahead. And many professional investors who missed out on the rally are desperate to deliver results as the year ends -- which could further push up stock prices.
But it would be wise for others to take those opportunities to exit on a high note -- and get an idea of how the economy will play out from the sidelines.
