Posted on January 10, 2011 by David Laidlaw 

While the markets gyrated wildly, 2010 was a good year for investors.  As illustrated in the table below, common stocks, bonds and commodities all produced solid returns. Last year, the markets started strong, faltered after European sovereigns appeared on weak footing, and surged again at the end of the year.

During the second half of the year, the prospects for stocks and bonds diverged. While the initial hints of the Federal Reserve’s program to buy $600 billion worth of Treasury and Mortgaged-backed securities was greeted with enthusiasm by the bond market earlier this fall, the bond market weakened and rates increased during the quarter.  On the other hand, stocks rose strongly to finish the year, increasing 23.3% since the beginning of July.

Fourth Quarter and Full-Year 2010 Total Returns

Stocks advanced since corporate profits were very strong. Over the first three quarters of the year, S&P 500 earnings increased by 38% compared to a similar period for 2009. This incredible earnings growth has been due to positive operating leverage that allowed companies to increase earnings at a faster rate than revenues. As a comparison, revenues grew a respectable 8% over the first ¾ of the year; however this rate is much slower than that at which profits advanced. Many companies are operating at peak margins and therefore corporate America will not be able to expand its profits at such a dramatic rate going forward.

There are a few trends that suggest that stocks will continue to advance during 2011. Stocks have positive momentum which can feed on itself for a while. For the majority of the year, most of the individual investors were pouring money into bond funds. According to the Investment Company Institute’s research, during 2010, roughly $254 billion net flowed into bond funds while $28 billion flowed out of stock based funds. This trend reversed itself at the end the year as about $15 billion flowed out of bonds and $4 billion came into stock-based funds.

Both the US and International economies should be able to support further growth. Those companies, both foreign and domestic, that operate in the emerging markets are experiencing rapid growth and will most likely continue to do so in the coming year. Even though China is raising interest rates, the Chinese economy is still predicted to grow over 8.5-9% in 2011, according to the World Bank. The vast majority of economic indicators are also positive in the US.  The domestic economy could also get an unexpected boost if hiring continues to pick up.

There are arguments against continued expansion of the equity markets. The European sovereign debt crisis has not been solved. There appears to be a large enough fund to support Greece and Ireland for the near future. However, if a larger country such as Spain were to experience trouble refinancing its debts, there is a possibility that the German public could exert enough pressure on its politicians to prevent future bailouts. This scenario would cause chaos in the currency markets and force stocks lower.

As discussed above, corporate margins are currently at a very high level. It is unlikely that profits will continue to expand at such a brisk pace. Finally, stocks are much more expensive than they were on a fundamental basis compared to last year and 2009. The S&P 500 is now trading at over 15X its earnings over the last twelve months. Given the recent sell-off in the bond market, stocks are also not as attractive as they were compared to bonds.  For example, for much of the past couple of years dividend yields on stocks were equivalent to the yield on 10-year US Treasury Notes. However, these bond yields are now significantly higher than the average dividend yield. As of the end of the year, the 10-year note yielded 3.34% and the S&P 500 dividend yield was 1.76%. We look more closely at free cash flows than dividend yields, but both metrics suggest stocks are less attractive than they have been in recent years.

Our net expectation is that the current momentum will carry stocks higher early this year. Even given the sell-off in bonds, we still view yields as too low to be attractive on an absolute basis. While we believe that stocks are still more appealing than bonds, longer term returns will be lower since valuations have increased and margins are already quite high.