What Comes Next After The Record Dow Jones Industrial Average Close?

whats nextRuss Koesterich: Tuesday’s record setting close in the Dow Jones Industrial Average (INDEXDJX:.DJI) was another reminder of how far equities have come in a relatively short time. Stocks in the United States are up roughly 20% from last summer’s lows.

Why? Fundamentals in the United States are generally favorable. Economic growth is slow, but corporate profitability is high and interest rates and inflation are both low. In addition, last summer investors were positioned much more defensively given concerns over Europe and the fiscal cliff. Though neither issue has been totally resolved, investors have celebrated the lack of a crisis by driving up stock multiples.

But while the rally has been good fun, I’m getting a lot of questions from investors about what comes next. Here are the questions, and my answers, below.

Q: Are US stocks still cheap?

A: On an absolute basis, stocks still look reasonably priced by most metrics. The S&P 500 is currently trading for roughly 15x trailing earnings, a bit below its long-term average of around 16.5. Valuations appear even more reasonable after adjusting for inflation, interest rates and corporate profitability.

Perhaps most importantly, stocks look very cheap relative to the alternatives: bonds and cash. Based on a comparison of the earnings yield on the S&P 500 to the yield available on an investment grade bond index, the S&P 500 appears to be the cheapest it has been in more than 30 years. While this is as much a matter of bonds being expensive as it is of stocks being cheap, equities offer the better long-term prospect, even after the recent rally.

Q: Can US stocks still move higher?

A: If fundamentals remain favorable, current valuations are not an impediment to the market moving higher over the remainder of the year. In fact, continued slow, but positive, economic growth; low inflation; and reasonable valuations should be enough to produce respectable returns for equities in 2013. That said we would expect more volatility in Q2 as the economy struggles with the cumulative impact of the tax hikes and sequester.

Q: What to worry about now?

A: There are obviously an unlimited number of issues that could derail the US market, but I would worry about two in particular: Europe and a movement away from the United States’ current “Goldilocks” economic environment. On the former, so far investors have taken last week’s chaotic Italian elections in stride. Should that change, and should Italian bond yields start rising back above 6%, I would expect another bout of risk aversion.

The second risk is closer to home. The US market has benefited from an economy that is healing but not healing fast enough to endanger the Fed’s asset purchase program. If we see either fiscal drag-induced economic weakening or evidence that the economy can stand on its own two feet – meaning the Fed could take its foot off the accelerator – I would expect some pullback in stocks.

Q: What to consider buying now?

A: While US stocks overall still look reasonably priced and cheap relative to bonds, some US sectors look expensive. In particular, I would be cautious on US consumer stocks – both consumer staples and consumer discretionary stocks – and US small caps, which all look extremely priced relative to fundamentals. At the same time, US energy, technology and mega cap stocks look like bargains now. These sectors are accessible through iShares Dow Jones U.S. Energy Sector Index Fund (NYSEARCA:IYE), iShares Dow Jones U.S. Technology Sector Index Fund (NYSEARCA:IYW) and the iShares S&P 100 Index Fund (NYSEARCA:OEF).

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

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