Can the Rally Continue? Here's the Evidence

It was another good day for stocks, as the Dow (DJINDICES: ^DJI  ) and the broader S&P 500 Index (SNPINDEX: ^GSPC  ) gained 0.49% and 0.15%, respectively. Both indexes set new five-year highs in the process.

S&P 500: Looking back and looking forward
Closing at 1,494.81 today, the S&P 500 is now nipping at the heels of the 1,500 mark, which it has only breached during two periods: March-April 2000 and May-Dec. 2007. Are there any lessons to be learned? The following table describes the environment at the starts of those periods against the current environment:

 

March 15, 2000

May 3, 2007

Jan. 23, 2013

S&P 500 Closing value

1,500.64

1,502.39

1,494.81

P/E, Trailing-12-month EPS*

28.0

16.7

15.0

P/E, Cyclically adjusted

45.0

27.4

22.6

EPS growth rate, trailing 4 quarters*

16.7%

12.8%

2.5%

GDP Growth, Trailing four quarters

4.8%

1.7%

1.6%

Unemployment rate

4%

4.4%

7.8%

*Based on operating earnings per share. Source: S&P Dow Jones Indexes, Robert Shiller, BEA, BLS.

The economic backdrop
In 2000 and 2007, we were at the tail end of two of the five longest periods of economic expansion since the 1850s. Today, with the Great Recession having ended in June 2009, we are still some ways from reaching even the average length of post-World War II expansionary cycles (59 months).

Earnings
In 2000 and 2007, earnings growth had been strong when the S&P 500 broke 1,500 (although it had begun to slow in 2007). Earnings growth has been very strong coming out of the 2008-2009, but it slowed sharply last year. Expected earnings-per-share growth for 2012 is just 2.5%, down from 15.1% the year before. However, I don't expect to witness a "cliff dive" in earnings, which is what happened post-2000 and 2007. Although current estimates for EPS in 2013 and 2014 look unrealistic, some contraction is certainly possible.

Stock valuations 
Whether on the basis of trailing-12-month earnings or cyclically adjusted earnings, stocks are much cheaper now than they were in 2000 and 2007, which is precisely why we're knocking up on a level that we first witnessed nearly 13 years ago (cyclically adjusted earnings are the average inflation-adjusted earnings per share over the prior 10 years.) While they don't look wildly cheap, stocks are primed to deliver to better returns from here than they did following the two prior periods (thankfully!).

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