Why We May See a Rally in U.S. Stocks

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With so much negative news dominating the headlines, investors can't be blamed for being worried or shying away from stocks. But if you take closer look at the market – specifically the Standard & Poor's 500 index – you might be surprised by what you see.

The S&P 500 is down just 3% year-to-date, and is actually up more than 5% over the past three months. The indexes for China, India, and Brazil, on the other hand, are all down over the past three months. Brazil's market index is down 19% year-to-date, China's is down more than 21% and India's is down more than 24%.

"People don't understand that the S&P 500 has now outperformed the BRIC nations (Brazil, Russia, India and China) for four years," Richard Bernstein, CEO and chief investment officer for Richard Bernstein Advisors, told USA Today. "We are in the very early stages of a resurgence of the U.S. equity markets, and I don't think people are aware of the shift that is going on."

Indeed, many analysts actually think U.S. stocks are cheap right now.

The price/earnings (P/E) ratio for the S&P 500 dropped to 12.8 as of the third quarter of 2011. The historical average for the S&P's P/E is 15, meaning stocks are moderately underpriced.

In fact, the average P/E has been even higher in recent decades. Since 1988 the S&P average P/E has been 19.2 – which translates to a 33% discount for current stock prices.

Four Reasons for a Rally

Corporate America has quietly been rebuilding since the financial crisis of 2008, but the constant barrage of bad news – the multiple disasters in Japan in March, budget battles in Washington, concern over the Eurozone debt crisis – has camouflaged much the progress that's been made.

"The pessimism today is actually creating opportunities for investors," Kate Warne, chief investment strategist at Edward Jones, told USA Today. "There are a lot of short-term concerns, a lot of serious risks, but investors really need to keep their eyes on the horizon, because we are also seeing strong fundamentals. And that is what is driving the market longer term."

Analysts have identified several positive signs – in addition to the relatively low S&P 500 P/E ratio – that indicate U.S. stocks are stronger heading into 2012 than many realize:

  • Cheaper commodities: The prices for commodities have fallen significantly since the first half of 2011, which should give corporate earnings a boost at least through the first couple of quarters of next year.
  • Lean and Mean: The fiscal discipline dictated by the financial crisis of 2008 has helped many companies weather the troubles of 2011. And now many companies are poised to quickly grow profits as soon as worries ease.
  • Dividend Increases: Companies that pay dividends have been increasing them, and that should continue. Despite the increases, the overall payout ratio has dipped to 29% from a 50-year average of 45%. Higher dividends mean a higher total return for investors, and provide some insurance against downturns.
  • More Buybacks: Buyback activity among U.S. companies rose to $439 billion in 2011 and is expected to rise to $500 billion next year. That sort of money flowing into the stock market helps boost prices.

With fundamentals strong, a run of positive news, or even neutral news, could be the catalyst that triggers a big rally in U.S. stocks.

"The volatility makes it difficult, but the fact that expectations are low is the best thing we have going for us," Ann Miletti, senior portfolio manager for core equity at Wells Fargo (NYSE: WFC) Advantage Funds told USA Today. "There is a lot of uncertainty in Europe, as well as domestically with our deficit and upcoming election year. But once we have all of the answers, it will already be priced into the market."

While some investors may worry about losing money by jumping into an uncertain market, there's just as much risk in missing out on profits once the market reverses to the upside.

"Investors tend to have terrible timing," write James O'Shaughnessy and Patrick O'Shaughnessy in MarketWatch. They pointed to a 20-year study by John Bogle, founder of the Vanguard Group, that showed average investors netting just a 7.9% annualized return, compared to a 13% return for the S&P 500 over the same period.

While investors still need to target solid, attractively priced companies, the general aversion to the U.S. stock market is no longer justified.

"The U.S. is the strongest corporate sector in the world," Bernstein told USA Today. "You have to look at how the U.S. is doing relative to everybody else. Surprise, surprise: We are doing just about the best."

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  1. Jane Foster Carter | December 20, 2011

    Please sign me up for the Monday Morning Newsletter. Thank you.

    Jane Carter

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