The last eight weeks have been very impressive for the S&P 500.  Since Sept. 1, the index has returned 13.27%.  The only substantial decline during this period was last week when China raised interest rates, but the selling only lasted one day and the market recovered its losses by the end of the week.

Much of the bullish sentiment for U.S. equities is based on the upcoming Nov. 2 elections and the presumed Nov. 3 Federal Reserve asset-buying announcement (QE2), both expected to be positive catalysts for riskier assets.

Also lifting stocks has been another better-than-expected earnings season.

Of the 171 S&P 500 firms that have reported, there have been a total of 145 positive surprises and just 25 disappointments.  These firms have posted decent revenue growth of 5.78% year-over-year.    Excluding financials, revenue growth looks even better at 10.33% year-over-year.  But soaring profit margins have been the primary driver of earnings growth.  Check out the table below of S&P 500 firms that have already reported third quarter earnings.

Profit margins for the S&P 500 are an impressive 12.12%, up from 11.45% in the second quarter and 9.72% a year ago.   All sectors are reporting year-over-year increases in margins, and five of ten sectors are reporting double-digit net margins so far.  Margin expansion has been a key part of the recovery in corporate profits, but this margin growth is a result of aggressive cost cutting that can’t continue forever. 

At some point revenue growth needs to take over, which means more consumer and business spending.  This may seem like a tall task given the weak consumer and business sentiment in the U.S., but S&P 500 firms may rely more on overseas sales going forward.  The S&P 500 already generates roughly 40% of operating profits outside the U.S. and that number may rise, especially since a weaker U.S. dollar boosts the profits from overseas sales.

I remain optimistic about the long-term prospects for U.S. equities.  Stocks are not cheap, but they aren’t ridiculously expensive either.  Those that argue that stocks are wildly overvalued often refer to the Shiller P/E – this conservative valuation measure shows that the market trades at 21 times its 10-year average annual earnings.  This is above the historical average, but this measure spent the entire 2003-2007 bull market above 25 as the market doubled.  The Shiller P/E is useful in some circumstances, but not all. 

Ultimately, I think the next ten years will provide nice returns for the patient investor (see Market Minute: Long-Term Investing).  As for the very near-term, the market may be due for some sort of pause or pullback following a couple of months of steady gains.  But it’s tough to fight the Fed, especially when they are printing money like crazy.

The Fed’s monetary policy won’t come without consequences.  Inflation is the most commonly discussed concern and something I’ve touched on many times before.  Extremely accommodative monetary policy may also lead asset bubbles, which are very messy once they pop.  I’m personally a little concerned with the investing world’s love affair with emerging market stocks and bonds.  Emerging markets have an awfully compelling investment case and I don’t doubt that they have room to run, but watching investors heedlessly pile into these volatile markets…it just makes me a little uneasy.

Peter Lazaroff, Investment Analyst

www.acrinv.com