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Stock prices poised to charge higher

By Dr. Peter Morici
web posted March 28, 2016

Stocks prices have recovered from their winter panic, but don't take money off the table. The American economy is on a solid footing and prospects are good for equities.

Stronger consumer and business spending should power GDP growth of about 2.5 percent for the balance of the year—boosting corporate profits from domestic sales. And the dollar has fallen against major currencies, raising the dollar value of overseas earnings on financial statements.

Anemic growth in Europe and the continuing dramas imposed by its immigration crisis, half-hearted labor market reforms, and constraints imposed by a single currency and fiscal austerity compel central banks to continue negative interest rate policies.

In Japan, a shrinking labor force and resistance to immigration and deregulation limit growth and compel accommodative monetary policies too.

In China, slower growth, the absence of competent financial market regulation, reliable accounting and limits on foreign ownership leave U.S. bonds and stocks as the last best alternative for private investors around the world.

U.S. Treasury data on capital inflows indicate continued strong global demand for U.S. corporate stocks and bonds. Even if the Fed manages, as anticipated, two quarter-point increases in the federal funds rate by December, returns on 10 and 20 year Treasury securities will not increase much—mirroring 2004-2006, when the Fed last pushed up short rates.

The average rate of profits for the S&P 500, which comprises about 80 percent of the publicly traded U.S. equities, is 4.42 percent and compares favorably with the 1.88 percent paid on 10-year Treasuries.

Even if the Fed pushes up short term rates further next year, these factors will drive foreign and U.S. investors into equities and away from bonds—raising stock prices.

At the same time, long-term sustainable price-earnings ratios for stocks are rising and make U.S. equities cheap.

The shift to a digital economy based on more intellectual capital—for example, computer apps that create companies like Uber and artificial intelligence that power the coming robotics —and less on hard assets—in particular, industrial buildings and machinery—greatly reduce the amount of capital businesses needs to create new and better products—the foundations of American wealth.

Google was launched with only $25 million in 1999 and grew into a $23 billion enterprise at its initial public offering five years later—the story repeated at ventures like Amazon and Twitter.

As established powerhouses like IBM and Ford rely more on software to create value in products sold, the demand for private capital to finance expensive investments in physical assets becomes more limited.

This is an important reason why established companies are flush with cash, even as they invest to improve the efficiency of production and responsiveness of supply chains, and expand product offerings and invest in promising new ventures.

Lower capital requirements coupled with an abundance of capital, thanks to foreign funds coming into America, are pushing down the expected rate of profit needed to attract funds into equity investments.

In turn, that pushes up the price-earnings (P/E) ratio markets can sustain—even if uncertainties abroad create the wider fluctuations in stock prices as recently experienced.

The S&P 500 Index is currently trading at about 2050 with a P/E ratio of about 22.61. However, factoring in expected profit growth over the next 12 months the P/E ratio falls to about 17.05.

That's well below its 25 year average of 24.88.

Assessed against alternative investments and history and given how much more efficiently digital technologies permit businesses to create wealth using investors' cash, stocks are hardly overvalued.

A P/E ratio approaching 25 is reasonable and coupled with expected growth in profits that could easily push the S&P Index up another 25 percent and past 2500. ESR

Peter Morici is an economist and business professor at the University of Maryland, and a national columnist. He tweets @pmorici1

 

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