Investors may be getting a bit antsy about stock valuations as U.S. markets repeatedly hit new heights, but many pros are insisting there is room left in this rally.
"We remain steadfastly bullish," Canaccord Genuity Corp. analysts Tony Dwyer and Michael Welch said in a report Wednesday. "We believe the market is far too inexpensive."
Among the factors supporting their enthusiasm are low inflation, the easy monetary policy of central banks, rising amounts of lending by banks, steady economic growth and record corporate earnings.
Canaccord's prediction that the Standard & Poor's 500 Index will rise 16 per cent between now and next year follows a similarly rosy forecast put out by Goldman Sachs earlier this week.
The New York investment bank told clients to expect another 5 per cent gain in the S&P 500 this year, a 9 per cent increase next year and an 11 per cent rise in 2015. Goldman's U.S. equity strategists argue that current conditions – including low interest rates and an expanding economy – support "an above-average S&P 500 valuation."
Even with the S&P 500 up 16 per cent this year, strategists say that the investing environment remains well balanced, with no signs the economy is sliding back into recession or harbouring inflation.
Canaccord calls this moment the "sweet spot," and the U.S. Federal Reserve made clear on Wednesday that it does not plan to do anything soon that would take the market out of this zone.
Addressing a Congressional committee, Fed Chairman Ben Bernanke said the growth of both the economy and the job market remained weak, and he warned that raising interest rates or reducing stimulative asset purchases too soon would put the recovery at risk.
Economists said Mr. Bernanke's remarks amounted to maintaining the status quo. It has recently become clear that the 19 members of the Fed's policy committee are openly split on whether it's time to begin reining in the massive stimulus efforts, but an end to the central bank's bond-buying program, known as quantitative easing, is not likely for at least a few months.
"We still think that the Fed will begin to curb its asset purchases before the end of the year, with a complete halt some time in the first half of 2014," Paul Ashworth, chief U.S. economist for Capital Economics, noted on Wednesday.
"The low level of core inflation and Fed policy has clearly had a positive effect on the markets. There is no evidence this is poised to change," Mr. Dwyer and Mr. Welch write in the Canaccord report.
They point out that U.S. payrolls and hours worked are showing steady and consistent improvement. In addition, the housing market appears to be in a "sustainable recovery." Finally, companies have easy access to capital, with the difference between yields on corporate bonds and 10-year Treasuries continuing to narrow.
Canaccord's strategists outlined recurring patterns from previous recoveries and concluded that markets are only halfway through their upward cycle.
In the most recent recoveries, when the core inflation rate was below 3 per cent, the average price-earnings ratio for stocks within the S&P 500 reached 19. For example, during 1984 and 1987, the average PE ratio rose from 9 times earnings to 20 times earnings and stocks' annualized return was 30 per cent. Between 1994 and 1997, the average multiple rose from 15 times to 22 times earnings and the annualized return was 33 per cent.
Canaccord considers 2011 the beginning of the latest period of PE expansion, calculating that the average PE ratio has risen since then from 12 times earnings to 16 times earnings today.
"We believe the biggest surprise of this cycle is that ultimately it will look like every other cycle," they write, adding that they favour the health care, financial, industrial and information technology sectors at the moment.