by Archie M. Richards, Jr., CFP^®
April 11, 2005

Investors have turned glum lately. The Wall Street Journal reports that Americans consider real estate a safer investment than stocks - by a huge margin of 80 percent to 13 percent. Also, for the first time in several years, some advertisements imply a pessimistic bias about stocks. A Merrill Lynch newspaper ad, for example, shows a walking man being followed by a bear.

Don't get sucked in by the pessimism. Conditions are terrific for a big rise in stock prices.

The market doesn't act as our intuition says it should. Here are a couple of examples:

• The Federal Reserve is raising short-term interest rates. Seems bearish, right? Wrong. In U.S. history, periods when short-term rates rose faster than long-term bond rates have been followed by rising stock prices.

• The government deficit is high, yes. But this condition has always been followed by big gains in stocks.

Here are other bullish factors:

• Corporate balance sheets are extremely healthy. Companies have cut costs and repaid debt big time. In September 2004, the "current ratio" of all corporations reached 1.23, meaning that current assets were 23 percent higher than current debts. This is the highest and most favorable level in many years. Corporate earnings are ripe for upside surprises.

  Corporations are also perched to increase their borrowing. Spending on capital goods such as factories, already expanding smartly, will do so even faster. Productivity (output per man-hour of work) will improve even more than it already has.

• Many people worry that so much U.S. government debt is owned by foreigners. Baloney! The entire nation is under-indebted.

  Here's an illustration: Say you can borrow money at 5 percent interest to build a factory that earns 10 percent on the investment. You'd be a fool not to borrow.

  The same applies to the entire nation. The United States has $97 trillion in assets. (There's some double-counting in there, but not much.) The U.S. also has $44 trillion of debt.

  The difference is the nation's net worth: $52 trillion. Our national income for one year is $12 trillion. This is a terrific return on our net-worth "investment." America's debt level is too low, not too high.

• Liberty and tax-rate reductions are advancing throughout the world. Improvements in government policies anywhere help people everywhere.

• This final item is the most bullish of all. For the first time in over 25 years, forward earnings yields throughout the world are significantly higher than the yields on 10-year government bonds. Here's an explanation:

  "Forward earnings" mean the estimates by professional stock analysts of corporate earnings in the next 12 months. The latest estimate for the S&P 500 stocks (representing 75 percent of the market value of all U.S. stocks) is $76.03.

  To find the forward earnings yield, we divide the forward earnings ($76.03) by the current S&P 500 Index (1181.20). This gives a yield of 6.44 percent. (That number is the opposite of the S&P's price/earnings ratio. Dividing the price (1181.20) by the forward earnings ($76.03) reveals that the S&P is selling for 16 times its forward earnings.)

  Okay, back to the forward earnings yield - 6.44 percent. The yield on 10-year U.S. Treasury bonds is currently 4.49 percent. The forward earnings yield is 43 percent higher. This implies the possibility that the market will rise by 43 percent.

  Since 1979, the forward earnings yield has generally been about the same as the 10-year Treasury yield. The numbers have differed sharply on only three occasions, as follows:

  1. In 1979, the forward earnings yield was much higher than the Treasury yield. Following this, the stock market went bananas on the upside. It didn't do so immediately, but the next big move was up.

  2. In 2000, the reverse prevailed. The Treasury yield became significantly higher than the forward earnings yield. Stock prices, you may recall to your sorrow, then took a terrific two-year tumble.

  3. The third sharp divergence is occurring right now. The forward earnings yield is significantly higher than the Treasury yield. The next move will be a big one on the upside.

In sum, don't be glum. The fundamentals are enormously bullish.