Sustainable Bull Market?

December 1, 2003

By Jonn M. Wullschleger, CFA

The powerful stock market recovery over the last year has many investors wondering if the gains have come too easy, too fast.  Are we back to the “irrational exuberance” of the late 1990s?  How can any rational investor be buying stocks after such a recovery?  Shouldn’t we be selling now?

While the market will not go straight up, there are several reasons to be optimistic about the next few years.  The real driver of any sustainable bull market is earnings growth.  We are entering a period of earnings growth driven by economic acceleration, increasing discretionary income, corporate capital spending and favorable monetary policy.

The economy has been expanding for almost two years and has recently accelerated.  Consumers have led the initial recovery as they were aided by lower mortgage rates and lower taxes.  Consumer spending will remain strong because there have been more than 2 million jobs added since January 2002.  These jobs have helped consumers stabilize their financial situation and increased their discretionary income.  For every $25,000 they spend, GDP will increase by $50 billion or 0.5%.

As the strength from the consumer continues, the next phase of growth will be driven by capital investment spending by America’s corporations.  Capital investment has been sluggish when compared to historical recoveries.  Many corporations have spent the last three years downsizing, repairing their balance sheets and postponing long-term capital decisions.  However, increased demand will force corporations to increase production.  Eventually more capacity will be needed to meet demand.  The increased spending will accelerate and drive the economic cycle.

The economy, consumer strength, capital investment and a favorable monetary policy are providing the cornerstone for a sustainable bull market.  There remains one last question that must be answered.  Is the market already pricing in this favorable outlook?

While the market has started to price in the recovery, there remains substantial opportunity.  The market’s 12-month forward PE is currently at 18.2 times, well below the 36 PE multiple reached in early 2000.  Given the current interest rate environment the stock market is not undervalued 

In summary, the current economic and financial trends are increasingly indicating that the long brutal three-year bear market is over and the economy and stock market are in a new expansion phase.  Patient investors purchasing high quality companies with dominant market positions, superior growth potential and attractive valuations have always been successful and we expect that formula will continue to work well for our clients.