After a Huge Quarter, What's Next for Stocks?

After suffering through 2008 and the first quarter of this year, stock bulls finally have something to crow about. In the second quarter, the S&P 500 rose 15%, turning in its best performance since the glory days of the second quarter of 1998. Are these gains sustainable?

Gainers and laggers
As the following tables demonstrate, some large-capitalization stocks turned in huge numbers, while others were left behind in the rally.

S&P 500 Gainers (among top 5%)

Company

Q2 2009 % Return

Cyclically Adjusted P/E Ratio*

Ford Motor (NYSE: F  )

130.8%

--

Bank of America (NYSE: BAC  )

93.5%

4.6

Dow Chemical (NYSE: DOW  )

91.5%

6.2

Capital One Financial (NYSE: COF  )

78.8%

5.8

Source: Capital IQ, a division of Standard & Poor's; author's calculations.
*Price divided by average earnings-per-share over the prior 10 years. Note that this P/E differs from the one cited for the S&P 500 below; the latter uses inflation-adjusted earnings.

S&P 500 Laggers (among bottom 5%)

Company

Q2 2009 % Return

Cyclically-Adjusted P/E Ratio

Bristol-Myers Squibb (NYSE: BMY  )

(7.3%)

14.5

Monsanto (NYSE: MON  )

(10.5%)

25.0

Best Buy (NYSE: BBY  )

(11.8%)

11.8

Source: Capital IQ, a division of Standard & Poor's; author's calculations.

Interestingly, despite significant stock price advances, the P/E ratios of our gainers remain substantially lower than the ones for our laggers. In the case of Bank of America and Capital One Financial, this reflects uncertainty concerning additional losses and normal profitability in a post-crisis economy.

What's the market worth?
At yesterday’s close of 919.32, the S&P 500 is valued at 15.75 times the average of its prior-10-year earnings, which is fractionally below the long-term average of this P/E ratio (16.3). That suggests that stocks are approximately fairly valued.

Bear in mind, however, that if the "new normal" growth rate in the economy is less than 2%, this will constrain profit growth, which in turn justifies a lower multiple. In that context (and for a couple of other reasons), I tend to believe that stocks are actually slightly overvalued, leaving them susceptible to a correction in the short term. (The average annualized growth rate in real GDP between 1929 and 2008 is 3.3%.)

Outlook: Fair, with pockets of real value
On a longer-term basis, stocks look moderately attractive right now (which may be good enough at a time when the alternatives -- government bonds, for example -- look singularly unattractive). Furthermore, despite the surge in stock prices since the market's March 9 low, pockets of genuine undervaluation persist. I recommend concentrating on 1) high-quality businesses and 2) financials. In the latter case, the uncertainty over appropriate valuations in this environment has created significant opportunity, while financial meltdown is now longer a threat.

Looking for specific names? Morgan Housel highlights three high-quality companies that are still cheap.

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Alex Dumortier, CFA, has a beneficial interest in Best Buy, but not in any of the companies mentioned in this article. Best Buy is a Motley Fool Stock Advisor recommendation and a Motley Fool Inside Value pick. The Fool owns shares of Best Buy. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (26)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 02, 2009, at 8:56 AM, WishToRetire2 wrote:

    Let's see if I've got this code language figured out:

    - when they say a stock is a hold, it means sell.

    - when they say the financial outlook is fair that means financial losses are to be expected...

  • Report this Comment On July 03, 2009, at 12:30 PM, 2XRAY wrote:

    How can the future of the US economy be bright when we are importing so much oil from the Middle East, so much hardware from China and exporting so little and have so much unemployment?

  • Report this Comment On July 03, 2009, at 7:00 PM, medixbio wrote:

    Going forward, the stock I love most is Thermogenesis(KOOL), 1st stem cell related company to turn profitable this coming quarter.

    plenty of cash, no debt. Simply the best hidden gem, could be a 5 bagger in 12 months.

  • Report this Comment On July 05, 2009, at 9:02 AM, thisislabor wrote:

    2xray, i don't think he said future outlook to be bright, i think he said the current s&p 500 is currently somewhere between appropriately priced and possibly slightly over valued but still attractive.

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