Almost there

There's an old saying that the stock market climbs a "wall of worry," and that's never been truer than this year, as US market indexes barrelled ahead, brushing aside concerns about economic weakness in Europe, China, and the US.

At its recent high, reached about a week ago, the Dow Jones Industrial Average was up 11% on the year and within 4% of its peak of 14,164.53, reached five years ago, on October 9, 2007.

Powered by Apple, Google, and General Electric, and other giant stocks, the Standard & Poor's 500 was doing even better, with a gain of 16.5% at its high, making it one of the strongest major indexes in the world.

The wall got steeper last week, as renewed fears about profits contributed to a 281-point drop in the Dow industrials, to 13,329, a 2.1% decline. The index is now 6% away from its 2007 high. While it may be too much to expect a new Dow high this year, it could easily happen in early 2013.

"Our own economic recovery looks more sustainable, and that is the key to higher stock prices," says Jim Paulsen, chief investment strategist at Wells Capital Management in Minneapolis. "A housing recovery is under way, bank lending is rising, consumer confidence is at a five-year high, and the unemployment rate is at a four-year low."

Like other strategists, Paulsen doesn't carry a price target for the Dow, but he stands by his early year call that the S&P 500 index could hit 1,500 by year end, 5% above Friday's close of 1,429. If that happens, the Dow could approach its high. Investors can play the index through the SPDR Dow Jones Industrial Average exchange-traded fund, now about $133.

Interviewed in the current issue, Blackstone Advisory Partners global strategist Byron Wien also looks for the S&P to approach 1,500 by year end. "The economy is stronger than the numbers reveal. That doesn't mean it's growing at 5%. But it does mean it is probably growing better than 2%," Wien said.

Despite the run-up this year, stock market valuations don't look excessive, especially given super low interest rates. The Dow industrials are valued at 13 times estimated 2012 earnings and at just under 12 times projected 2013 profits. The S&P 500 is pricier at 14 times this year's estimated profits.

The so-called earnings yield - the inverse of the price/earnings ratio - on the Dow is around 8%, a very wide 6% above the yield on 10-year Treasuries. The index's dividend yield stands at 2.5%, with plenty of room to rise, given that the payout ratio is less than 35%. IBM, ExxonMobil, Disney, Caterpillar, and Travelers are just some of the Dow components with ample ability to boost their dividends.

The Dow industrials are more reasonable now than at the 2007 peak, when the index traded for 16 times the then current 2008 earnings estimates. That projection turned out to be way too high, as did even more bullish 2009 projections at that time, as the financial crisis and recession savaged earnings.

Former Dow components Citigroup and AIG are both down more than 90% since then, adjusted for reverse stock splits, while another erstwhile Dow member, General Motors, filed for bankruptcy in 2009, resulting in a near total wipeout for shareholders.

The accompanying table shows the performance of the 30 current Dow industrials since the October 2007 market peak. At a time when many institutional and retail investors favour index investments over active management, the table makes a powerful case for stockpickers because of the huge disparity in returns of the individual Dow components in just five years. Home Depot and IBM lead the pack with gains (excluding dividends) of about 75%, while Bank of America and Alcoa are down about 80%.

There has been a net change of five companies in the Dow since 2007. Travelers, Cisco Systems, BofA, Chevron, and UnitedHealth joined the 116-year-old average while Citigroup, AIG, GM, Altria, and Honeywell fell out. Kraft Foods joined in 2008 and left recently as it split into two companies.

Probably the key market risk is a slowdown in profit growth. Current S&P 500 profit estimates of $103 and $115 for 2012 and 2013, respectively, are down about 3% from early year projections.

Third quarter S&P earnings are expected to fall 1%, the worst showing in three years, hurt by double digit profit declines in the material and energy sectors. Earnings warnings came last week from normally reliable Chevron, as well as Cummins, a leading maker of diesel engines.

"For equities to march substantially higher, there needs to be economic validation," says Mark Luschini, strategist at Janney Montgomery. A more bullish Paulsen says that profit growth is unlikely to resume at a robust rate in the next 12 months, but that the market P/E ratio may continue to expand, lifting major indexes. The S&P P/E already has moved up about two multiple points.

It's bullish that US stocks have done well without much participation by retail investors, who continue to prefer bonds despite historically low rates on Treasuries, mortgage securities, high-grade corporate debt, and junk bonds. The average junk-bond yield of 6% is only 3% higher than dividend yields on scores of high-quality, dividend paying stocks.

Junk bonds probably can't go much higher, although they could go a lot lower. If retail investors ever warm to stocks, the Dow could go much higher.

Even with the Dow's advance this year, none of its components trades for more than 20 times estimated 2013 profits, and only a handful fetch more than 15 times forward earnings. Six have single-digit P/Es: JPMorgan Chase, Chevron, Caterpillar, Microsoft, Cisco, and Hewlett-Packard.

The H-P P/E multiple of 4 isn't a misprint. That alone ought to attract the attention of value oriented investors, plus the possibility of a corporate breakup instigated by activist investors. Three of the other Dow tech stocks, Microsoft, Intel, and Cisco, all trade at about 10 times forward earnings, and the P/E ratios of cash rich Microsoft and Cisco effectively are lower than 10 when their cash is stripped away.

Microsoft, at $29, and Cisco, at $18, both have about $6 a share in net cash.

Some of the high-P/E Dow stocks, including Home Depot, Verizon Communications, and Procter & Gamble don't look as attractive. Home Depot may already discount an upturn in housing, while Verizon's P/E is high historically at a time when its core wireline business remains under pressure.

Underperforming P&G has been targeted by activist investor Bill Ackman. At $68, its shares anticipate some improvement in its operating results.

With a bevy of reasonably priced stocks, the Dow industrials look poised to set a new record, if not this year then next, and investors can get a nice 2%-plus yield along the way.

- By Andrew Bary