by Archie M. Richards, Jr.
March 26, 2007

In a recent column, I noted that unqualified optimism among Chinese investors signaled a bear market in Chinese stocks that would probably drive U.S. stocks to new lows.

The U.S. market subsequently fell almost to new lows and has risen since. The Chinese market has continued rising. I don't know when Chinese stocks will begin a serious decline, but I now presume that U.S. stocks will be little affected, because in other ways their prospects are extremely promising.

The recent decline supposedly occurred because of the possibility that foreclosures of subprime home mortgages will affect the entire economy. The danger to housing stems from adjustable-rate home-mortgage loans taken out from 2004 to 2006. I accept an expert's estimate that increases in payment requirements on those mortgages will cause about 1.1 million foreclosures. But these should occur over 6 to 7 years and represent only about 1 percent of all home-mortgage loans - too insignificant to worry about.

On February 27, 2007, the S&P 500 fell 3.5 percent. Since 1979, the S&P has suffered single-day declines of 3 percent or more on 38 days. Following 31 of those days, the Index has been higher 60 days later, with the average gain 6.8 percent.

Most importantly, stocks are cheap in relation to bonds. Here's what I mean:

The 500 stocks in the S&P 500 Index will probably earn about $90 this year, before nonrecurring items. This $90 amounts to 6.27 percent of the index level of 1436 (90 divided by 1436). That's called the "earnings yield." It's the opposite of the S&P's price-earnings ratio of 16 (1436 divided by 90).

Okay, the S&P earnings yield is 6.27 percent. But the interest yield on 10-year Treasurys is only 4.61 percent.

Normally, the S&P earnings yield is lower than the Treasury interest yield. At the market peak in 2000, the earnings yield at 3.5 percent was considerably lower than the interest yield of 6.5 percent, signaling a bear market in stock prices. (How I wish I'd know about this at the time!)

All right, back to the present. With the S&P earnings at $90, the index would have to rise to 1952 for the earnings yield to equal the current interest yield of 4.61 percent (90 divided by 1952).

The S&P Index now stands at 1436. It would have to rise by 36 percent to reach 1952. It would have to rise even more for the earnings yield to be lower than the interest yield. And the S&P would have to rise even more if earnings rise and interest rates fall, as I expect.

Compounding the good news, companies are buying back their own stock from the public in great numbers. Other companies are merging with or buying their competition. Private equity companies are buying public companies right and left. In most cases, debt is incurred to buy stock, all driven by the stock earnings yield being lower than the bond interest yield. The removal of hundreds of billions of dollars worth of stock from public ownership is creating a shortage that will drive up prices all the faster.

Another key factor: The 3rd year of the U.S. presidential term (this is Mr. Bush's 3rd year) is invariably a good year for stocks. Since 1943, there have been 16 third years. The market rose in every single one. In two of those years, it rose only 5 percent. In the other 14, the gains were 10 percent or more.

The prospects for foreign stocks are even better than those of U.S. stocks. Foreign stocks are discounted in relation to debt even more than is the case in the U.S. And during the third years of U.S. presidential terms, the gains of foreign stocks since 1943 have averaged more than 20 percent.

Worldwide, this will be an excellent year for stocks. Next year should be good, too. If you haven't bought index funds or exchange-traded funds of U.S. and foreign stocks, do it now.