Happy birthday, bull market!
Today, the current bull run in stocks celebrates its second birthday. Since March 9, 2009, the S&P 500 has nearly doubled, and while it remains below the pre-recession peak set back in 2007, investors who stayed the course have made back quite a bit of their money. Of course, now that we are well into one of the biggest market rallies in decades, some investors are starting to get a bit nervous. After all, how long can a good thing last?
Staying power
Well, if you're Laszlo Birinyi of research and money management firm Birinyi Associates, this current bull market still has some staying power. Birinyi, who gained fame by accurately calling for investors to buy stocks right around the market bottom two years ago, predicts a "long and durable bull market" that should continue for several years. Hedge fund manager Barton Biggs concurs, based on his belief that valuations are still below historical averages and that economic and profit growth will fuel further gains. Supporting this view, Bloomberg's recently complied analyst estimates show that companies in the S&P 500 are on track to boost earnings by 17% in the next year.
Of course, it's not all clear sailing ahead. Rising oil prices, unrest in the Middle East, and fiscal strains in parts of the debt-laden eurozone all have the potential to derail our economic recovery. And depending on which measure of valuation you use, the market may not be as undervalued as some people believe. While the market may be undervalued or fairly valued according to many traditional P/E measures, economist Robert Shiller has popularized an alternate method of calculating earnings that shows the market is currently selling at a premium. A cyclically adjusted P/E measure, which smoothes earnings over a 10-year period, shows that the market is currently trading at a P/E of 23.5, significantly above the long-term average of 16.4. So depending on how you look at things, continued market outperformance is not a sure thing.
Room to run
For the most part, I agree with Birinyi's upbeat assessment, although I'm not as optimistic as he is. I do think the stock market will offer the highest gains in the coming years, compared with the alternatives of cash or bonds. However, given the general run-up in prices in recent years, there is a lot more risk in the stock market now. I do think the market is likely to put up a positive return in 2011, but those gains probably won't be of the same magnitude as they have been in recent years. With the S&P 500 Index returning 26% in 2009 and 15% in 2010, my bet is that the market index will return somewhere in the mid-to-high single digits by the end of this year.
There's a historical basis for my estimate here. According to data compiled by Prudential Financial, for the last nine bear markets since World War II, the average stock market return in the year following the market's bottom was 36%. The average return for the second year was 12% and for the third year was just 1%. This is consistent with the idea that most of the post-recession gains come immediately following the worst of the downturn. So while the market may gain ground this year, gains are likely to be more modest. Investors should also be prepared for a short-term pullback -- such an event would not be unexpected at this point in the market cycle.
The next phase of growth
And while I urge long-term investors to stick with their stock market allocations, you do need to play it smart when it comes to the next phase of this bull market. History has shown that, on average, market leadership takes a definite shift during the third year of the bull market. It is typically somewhere around this point that large-cap stocks begin to outperform their small-cap counterparts. So make sure you're not loaded up on small caps from their great run over the past decade. If you need quick, cheap exposure to large-cap names, consider an index fund or exchange-traded fund like the SPDR S&P 500 ETF.
While history is definitely not a perfect predictor of future trends, there have been certain sectors of the market that have tended to outperform in the third year of a bull market. Sam Stovall, chief investment strategist for Standard & Poor's Equity Research Services, points out that since 1970, the energy, utilities, health care, and consumer staples sectors have done well at this point in the game as the economic recovery tends to mature and growth slows.
One mutual fund that is taking this advice to heart is First Eagle Fund of America (FEFAX). Longtime managers Harold Levy and David Cohen place a priority on protecting their fundholders, and have positioned the portfolio with a heavy allocation to industrial, health care and energy names. The fund has a roughly 4% allocation to SPDR Gold Shares (NYSE: GLD) to protect against inflation and a depreciating U.S. dollar. Health-care names like Canada's Valeant Pharmaceuticals (NYSE: VRX) and medical equipment supplier Baxter International (NYSE: BAX) are also favorite picks, with Valeant trading at a very reasonable 12.8 forward P/E and Baxter boasting a hefty 2.3% dividend yield and 64% cumulative growth in its dividend over the past three years. Energy names also account for a good-sized portion of fund assets and include Devon Energy (NYSE: DVN) and Dresser-Rand Group (NYSE: DRC), which should benefit if oil prices continue their upward trajectory.
Ultimately, the stock market should continue to produce solid returns for investors, despite some increasing risks and potential setbacks. To navigate this next phase in the economic recovery, investors will need to make careful investment choices and watch closely as this new phase plays out in the market.
As the bull market ages, you need to keep track of your stocks now more than ever. Start a watchlist today and get the help you need; by adding any company or ETF you want, you'll get valuable updates on the latest news about your favorite investments. Also, you'll get immediate access to a new special report, "6 Stocks to Watch from David and Tom Gardner." Click here to get started.
