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A case for stocks now

An improving economy and strong profits could keep stocks climbing, despite higher prices.

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In 2014, stock markets have continued the run that started in 2009, with the S&P 500 Index® notching dozens of all-time highs and breaking through the 2,000 level for the first time as the economy has shown signs of strength and corporate profits have continued to creep higher. But amid all the good news, some investors have grown nervous that the markets are due for a correction or that stocks have reached the kind of heights that preceded the major bear markets of 2001 and 2008.

While no one knows what could happen in the short term, Fidelity growth managers Sonu Kalra, who manages the Fidelity® Blue Chip Growth Fund (FBGRX), and Gavin Baker, who runs the Fidelity® OTC Portfolio (FOCPX), recently made the case that stocks could continue to deliver attractive returns over the longer term, thanks to strong fundamentals and secular growth trends.

A different market

Investors who are worried that stocks are overvalued may look back at previous highs nervously. The S&P 500® Index was around 1,500 before each of the last two major pullbacks, well below recent levels of 1,960. But things have changed since those previous highs. A key difference has to do with corporate earnings. Back in 2000, the S&P produced $57 in profits per share; today, that level has risen to $114 per share.

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In fact, earnings increases have outpaced stock gains, causing valuations to drop compared with previous peaks. For instance, in 2000 the S&P price-to-earnings (P/E) ratio was more than 30, while in July 2014 it was 17. Still, it is hard to make the case that stocks are cheap today. The average P/E ratio since 1926 has been about 15, and in 2009 the S&P traded close to 12.

“Valuation remains pretty close to historical norms, above the historical average but not dramatically above it,” says Kalra. “I would describe the market overall as fairly valued—but that doesn’t mean we can’t continue to see gains. The U.S. economy continues to grow at a slow but steady pace and, historically, bull markets have ended with a slowdown in the economy. But given that we are in the fifth year of a bull market, I do think you need to be selective about what you own and look for real opportunities.”

The economic backdrop

Ultimately, stock market returns tend to follow corporate earnings. Today, there are some reasons for optimism regarding the outlook for corporations. Revenues have continued to grow in a slow and steady fashion, up 4.3% in the June quarter, compared to last year. At the same time, while mild inflation has been keeping input costs low, and low interest rates have reduced debt burdens and capital costs for many corporations.

All this has translated into higher profit margins, with the S&P 500 delivering 8% net earnings growth in Q2 2014 compared with the same period a year ago. At the same time, many companies have taken advantage of low rates to decrease the cost of debts. As that cash has dropped to the bottom line, companies have stockpiled nearly $2 trillion in cash that may benefit investors through share buybacks, dividends, or reinvestment.

“If you look at what has happened since the 2009 bottom, revenues for the S&P 500 are up about 23 percent, while profits are actually up six times in that time frame,” says Kalra. “So corporations have really focused internally on improving operations and margins.”

Riding a recovering economy

While the economy is far from red hot, the slow, steady gains that have been made may provide some wind at the backs of corporations. GDP rebounded from a lackluster winter, with 4% growth in the second quarter of this year, along with strong hiring reports for the job market. The economy has been benefiting from improvements in the housing market, which have the potential to be an enduring change due to pent-up demand, affordable prices, and a lack of supply. (See the chart right.) The economy has also been benefiting from big reductions in energy costs, thanks to new production techniques in the United States, and a resurgence in domestic manufacturing.

Strategies to look for growth

With stocks fairly valued and the economy expanding, albeit slowly, investors may want to consider seeking pockets of growth that are outpacing the economy overall. Historically, the market has rewarded companies that have been able to produce double-digit growth.

“I think we’re going to see more change in the next twenty years then we have seen in the last fifty years,” says Baker. “It is a great time to be alive and a great time to be a growth investor.”

Where to look for growth

Here are some corners of the market where our experts have found opportunities.

E-commerce—The share of retail purchases made online is just around 10% today, but could grow rapidly in coming years. This may provide a tailwind for online retailers, payment providers, companies that help local businesses create an online presence, and others.

Cloud computing—Companies are moving away from the dominant computer model of the last decade to the cloud—where remote servers house applications and data. This shift may create huge potential, particularly for companies that offer software as a service (SaaS).

Internet advertising—American’s media habits have shifted, with more and more time spent online. But advertisers haven’t kept up. In fact, a significant gap exists between how much time people spend online and the portion of advertising dollars spent there. As this gap decreases, online advertisers and content creators may benefit.

Health and wellness—Consumers have shown an increasing appetite for products connected to health and wellness, including organic foods and active wear.

Personalized medicine—Over the past decade, the cost to decode the human genome has come down precipitously. As knowledge from this research spreads, a wave of innovative medicines has arrived, many of which target diseases and patients more precisely.

The dangers of market timing

Stock investing can be nerve racking. When things are bad, you may wonder if things are going to take another step down. When things are good, you may wonder when the other shoe will drop. But trying to time the market to avoid corrections or short-term losses is difficult at best.

Indeed, as the chart below shows, if you do leave the market and miss out on the best days, it can be hard to make up that time.

It may be better to stick with your asset mix, rebalance at least once a year, stay diversified, and—if you are inclined to make more tactical bets—tilt toward corners of the equity market where you find growth opportunities.

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Past performance is no guarantee of future results.
The information presented reflects the opinions of Sonu Kalra and Gavin Baker as of August 19, 2014. These opinions do not necessarily represent the views of Fidelity or any other person in the Fidelity organization and are subject to change at any time based on market or other conditions. Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund.
As with all your investments through Fidelity, you must make your own determination as to whether an investment in any particular security or fund is consistent with your investment objectives, risk tolerance, financial situation, and your evaluation of the investment option. Fidelity is not recommending or endorsing any particular investment option by mentioning it in this article or by making it available to its customers. This information is provided for educational purposes only, and you should bear in mind that laws of a particular state and your particular situation may affect this information.
Indexes are unmanaged. It is not possible to invest directly in an index.
The S&P 500 Index is a market capitalization–weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the possible loss of principal.
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