The Health of the Stock Market

10/30/2017 11:30 am ET

Headlines such as "Stock Rally Can’t Continue Much Longer, The Stock Market Could Crash 50%, Says Former Congressman Ron Paul" and "How To Weigh The Odds Of A Stock Market Crash" have investors concerned. Many investors fear a dramatic market reversal, yet don’t want to get left behind as they witness stocks continuing on an upward trajectory. In what can only be referred to as the most unloved market advance in recent memory, why should investors continue to be bullish on stocks? The answer is a combination of a growing economy and rising corporate earnings.

Last Friday, the U.S. Department of Commerce announced that real gross domestic product (GDP) increased at an annual rate of 3.0 percent in the third quarter of 2017. This follows an increase of 3.1 percent in the second quarter. This was the first six-month period since 2014 in which real US GDP grew more than 3.0 percent in consecutive quarters. While this growth may not be robust, it is a strong showing given the devastating series of hurricanes that hit the U.S. in the third quarter.

The news on the corporate earnings front has been extremely positive. With over half of the S&P 500 companies reporting so far this earnings season, analysts forecast that when it is all said and done corporate earnings will have risen about 8 percent. In addition, 63 percent of companies reporting have been buying back stock at a robust 4 percent rate. What this means is that even with no change in absolute earnings, earnings per share would rise 4 percent as those earnings are being spread over fewer shares. When a company the size of Alphabet (with a current market cap of over $700 billion) can grow revenues at 24% year on year and net income by even more, something meaningful is going on with corporate earnings.

The possible catalyst for a market decline is the specter of rising interest rates. Simply put, in a rising interest rate environment stocks perform markedly worse than in a falling rate environment. In Invest With The Fed (McGraw-Hill, 2015), Gerald Jensen of Creighton University, Luis Garcia-Feijoo of Florida Atlantic University and I found that from 1966 through 2013 when rates were rising, the S&P 500 only returned 5.9 percent annually. In contrast, when rates were falling, the index returned 15.2 percent annually.

The ten-year Treasury bond is now yielding 2.39 percent, which is historically very low. However, this yield has increased substantially over the past six weeks, rising from a low of 2.06 percent on September 8th. Instead of checking continuously on levels of the stock market, investors may be wise to keep an eye on the usually boring bond market. It likely holds the clues to the stock market’s future in the near and intermediate term. In the long term, the broad group of corporate earnings represented by the S&P 500 should be meaningfully higher in the future, and the market that represents those earnings will march ahead accordingly.

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