So much for a summer swoon.
After tumbling around 5% in mid-June, stocks have resumed their upward march with the S&P 500 (.SPX) recently hitting record highs. At roughly 1,680, this index of 500 of the biggest U.S. stocks has surged nearly 18% so far this year, eclipsing many market strategists' price targets for the end of the year.
What does it mean for investors? Should you buy, sell or hold? Here's a Q&A with some perspective and tactical tips if you're thinking of making adjustments to your portfolio.
Q. What's fueling the rally?
A. There's no single driver for the stock market's rally — now entering its fifth year — but analysts generally cite two major catalysts: the Federal Reserve's monetary policies and reports indicating the economy is expanding at a slow, but gradual, pace.
For months, the Fed has been injecting cash into the economy and financial markets through its program of buying government-backed bonds. Stocks sank in June after Fed Chairman Ben Bernanke said the $85-billion-a-month program may wind down this year. But stocks rebounded after Bernanke later said in a speech that the central bank's "highly accommodative" monetary policy will be needed for the "foreseeable future."
The markets hang on Bernanke's every word, and his testimony before Congress this week may spark another bout of volatility. Bernanke stressed Wednesday that the Fed hasn't set a timetable for ending the bond-buying program and could even extend it if the economy weakens—comments that helped lift stocks.
Recent economic data, moreover, suggest the economy is holding up, which should generally be positive for corporate profits and stocks. Economic growth picked up to a 1.8% annual rate in the first quarter from 0.4% in the fourth quarter. Unemployment ticked down to 7.6% in June. Housing and auto sales have been rebounding. And an index of leading economic indicators has been trending higher for six months, according to the Conference Board, a research firm in New York. That could bode well for economic growth in the second half of the year, the group said in a report in June.
Granted, there are reasons for caution. Goldman Sachs (GS) and JP Morgan Chase (JPM) recently trimmed their forecasts for second-quarter economic growth to 1%. The global economy is slowing as well: The International Monetary Fund recently cut its global growth forecast for 2013 to 3.1% from 3.3%, due largely to weakness in emerging markets and the deeper-than-expected recession in Europe.
Some money managers, meanwhile, suggest investors not get carried away with the stock rally.
"We continue to suggest a cautious, moderate course," says David James, a portfolio manager with James Investment Research in Xenia, Ohio. The economy has made some improvements, he notes, but "nothing that suggests the risks have completely subsided."
Q. Are stocks still "cheap?"
A. It depends on how you define "cheap." Stocks aren't as inexpensive as they were four years ago, or last year, for that matter, according to some measures comparing stock prices and corporate earnings. The S&P 500 is trading at 18.4 times earnings for the past 12 months versus 15.2 times a year ago, indicating stocks look 21% pricier today.
Stocks look cheaper if you look forward, trading at 14.8 times estimated profits for the next 12 months. But analysts tend to be overly optimistic about earnings and companies in the S&P 500 have been steadily lowering their own forecasts for second-quarter profits. Those reports are rolling in now.
The current average forecast on Wall Street is for 3.3% growth in earnings per share, down from 8.4% in January, according to Thomson Reuters I/B/E/S. Revenues are expected to grow just 1.2%. Moreover, 97 companies have announced they'll miss forecasts while only 15 companies have made positive pre-announcements. If the trend persists, it will be the most negative earnings guidance since the first quarter of 2001.
Rather than rely on near-term estimates, some money managers prefer to use the 10-year cyclically adjusted P/E ratio, or CAPE. Developed by Yale economics professor Robert Shiller, the CAPE uses an average 10 years of earnings, adjusted for inflation, to calculate the market's P/E ratio — aiming to smooth out the ups and downs of the economy and corporate profits.
By that measure, stocks don't look cheap either. Historically, the CAPE has averaged 16.4. It's now 23.8. Though that's not a record high, it may not be a good sign for stock returns over the next decade. Since 1926, when the CAPE was between 21 and 25, "real" returns averaged 0.9% over the next decade, adjusted for inflation, according to research by Cliff Asness, co-founder of AQR Capital Management in Greenwich, Conn.
"The fundamentals are not especially strong for U.S. stocks, which are overvalued on a CAPE basis," says Laura Scharr-Bykowsky, head of Ascend Financial Planning in Columbia, S.C., who has been trimming stock exposure for her clients.
So far, none of this has stopped stocks in their tracks. The 10-year CAPE has hovered above 20 since October 2010 while the S&P has surged around 46%. And while corporate profit growth has slowed, it hasn't curbed enthusiasm for U.S. stocks, partly because bonds yields are so low, offering meager returns at current rates.
Also, stocks don't look pricey based on other valuation measures, says Dirk Hofschire, senior vice president of asset allocation research with Fidelity Investments. Looking at the 5-year CAPE, stocks now trade around 16 times earnings, he points out. Since 1926, stocks have averaged a 5-year real return of 6.6% when the 5-year CAPE has been around that level.
"As long as economic fundamentals continue to improve, the backdrop should be positive for stocks," he says. While stock prices have recently increased faster than earnings, profits had previously outpaced prices and the market may now be catching up, he says. Plus, P/E ratios have limited predictive power in the short term, he adds.
Q. Should you buy, sell or hold?
A. How much to invest in stocks depends on your time horizon, risk tolerance and other investments in your portfolio. Most advisers recommend holding 60% to 70% in stocks if your horizon is 20 to 30 years. And checking the market frequently isn't advisable. Several studies have found that investors become more risk-averse the more they check the market.
One move to consider now is rebalancing, says Scharr-Bykowsky, the South Carolina adviser. When markets are rallying, it's tempting to ride the wave. But according to one 2012 study, portfolios that are rebalanced "significantly outperform a buy-and-hold strategy," regardless of whether one rebalances periodically or based on other methods.
Scharr-Bykowsky suggests selling some equity positions to lock in gains and adding to areas that haven't fared as well. It may be a good time to buy bond funds, she adds, taking advantage of the recent increase in rates. (Bond prices and interest rates move in opposite directions.) One fund she uses for her clients is the DoubleLine Core Fixed Income Fund (DLFNX), which invests in a range of fixed-income securities and currently yields 3.4%.
Another downtrodden area is emerging markets. Economic growth is slowing in major markets like China, India and Brazil, and their stock markets have been some of the worst global performers this year. Overall, emerging markets are down around 10% with Brazil tumbling 18%, according to index provider MSCI.
These markets may not recover soon, especially if China's economy keeps weakening. But their troubles may now be reflected in stock prices, offering a good entry point for long-term investors, says Carl Macko, an adviser with Synergy Capital Management in Atlanta. Macko has been rebalancing into emerging markets for his clients, increasing exposure to 7.5% of their stock portfolios.
One option: the iShares Core MSCI Emerging Markets ETF (IEMG). The fund tracks an index of major stocks across the developing world, and it has an expense ratio of 0.18%, well below the category average of 0.76%, according to Morningstar.
Some REITs and dividend-paying stocks also look attractive, according to some money managers. Many of these stocks took hits in June as interest rates spiked. But the stocks have rebounded with the broader market and they may offer compelling long-term opportunities, according to some investing pros. For seven stock ideas, see Is Dividend Investing Dead?
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.