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Stock Market Surges On -- But Is It Sustainable?

The stock market rallied to new highs in mid-May, as investors continued to ride the momentum from a surprisingly good jobs report that came out at the beginning of the month.

Investor sentiment has a great deal to do with how news is interpreted, and even reported. Not only have stock market bulls made the most of that recent jobs report, but they are now seizing on anything that can be interpreted as good news as another excuse to push stock prices higher. Unfortunately for more conservative investors in savings accounts and other deposits, banks will not be so quick to embrace this optimism by raising rates.

Bullish news

A widely reported indicator of stock market valuation reached a 58-year high recently. This indicator is the ratio of the earnings yield on stocks to the yield on Treasury bonds, and it is a good proxy for a of couple fundamentals that go into stock valuation, namely:
  1. Prices relative to underlying earnings. Stock prices have gone up by a tremendous amount over the past several decades, but that doesn't mean that stocks keep getting more and more expensive. What matters from a fundamental investing standpoint is how much prices go up relative to the underlying earnings. So, everything else being equal, a stock selling at $20 a share with $2 a share in earnings should look the same to an investor as a stock selling at $40 a share with $4 a share in earnings. Both stocks would have a price-to-earnings (P/E) ratio of 10, and the earnings yield is simply the inverse of that P/E ratio.
  2. The discounting value of interest rates. By comparing the earnings yield on stocks to bond yields, investors are acknowledging that interest rates discount the value of future earnings. The higher interest rates are, the less valuable future earnings appear. However, with interest rates as low as they are now, future earnings are not discounted by much, which makes stocks appear more valuable.

Because fundamental stock valuation is a function of prices, earnings and interest rates, stocks can be hitting new highs and still appear like a good value, as long as earnings have grown and/or interest rates are low.

The sobering facts

While the stock market is quick to celebrate any sign of good news these days, there are some more sobering facts about the current economy -- chiefly the fact that unemployment remains stubbornly high.

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