Fighting the "Fundamentals"

How should one interpret the market rally?

One widely-held viewpoint is that the rally has occurred despite weak fundamentals.  This means the market is over-extended and due for a correction or even a crash.  Those taking this position cite continuing high unemployment, a continuing high rate of foreclosures, threats to commercial real estate, the "spent-up" consumer, high debt levels, and a generalized concern about government policy.

These have all been the factual backdrop for many months.  These factors have not changed.

Another Approach

An alternative viewpoint is that the US equities in March reflected a worst-case scenario, revisiting depression conditions.  If conditions -- still bad -- improved from those levels, then many individual stocks deserved higher valuations.

What has changed since March?  Two things - -both important.

Forward Earnings.  Ed Yardeni follows the forward earnings estimates quite closely (subscription required).  He writes as follows:

Earnings are turning.

S&P 500 forward earnings is turning up rather nicely and consistently since

it bottomed at $62.92 per share during the week of May 8. Last week, it was up

12% from the bottom to $70.49. It’s up for 17 weeks in a row to the highest

level since January 23. As 2009 ends, forward earnings will converge to

analysts’ consensus expected earnings for 2010. This estimate has also been

moving higher from a low of $73.37 during the week of May 8 to $75.29 last week

Interest Rates.  Investors have a choice in asset allocation.  When there are extremely high corporate bond rates, this is an attractive alternative to stocks.  If one is taking a risk in buying corporate paper instead of Treasuries, the return should be compared to expected stock gains.

The Atlanta Fed does a nice job of summarizing many economic indicators.  Here is a recent look at corporate credit.

There is an obvious improvement in corporate yield spreads.  Lower yields make corporate paper less attractive in comparison to stocks.

Credit default swaps show the same picture.

Conclusion

However one defines the "fundamentals" it should not be a static concept.  The data show that stocks have less risk and more potential reward than was the case a few months ago.

Those choosing a static definition of the fundamentals -- looking at backward earnings, for example -- miss out on the changes in risk and reward.

Considering these data, one could easily make the case that stocks are just as attractive now as they were last Spring.  Prices are higher, but risk/reward is also better.