Why investors should stick with US stocks

Stocks are trading near record levels, but I don't advise taking money off the table. Even with slow growth abroad and the Federal Reserve raising short term interest rates, I believe the bull market will continue.

Anemic GDP growth in Europe and the drama associated with sovereign debt will continue thanks to structural barriers imposed by half-hearted market reforms in Germany and elsewhere, barriers to price level adjustments among national economies created by a single currency and constraints on expansionary fiscal policies required by euro-zone rules.

Traders work on the floor of the New York Stock Exchange
Brendan McDermid | Reuters
Traders work on the floor of the New York Stock Exchange

In Japan, a low birthrate and resistance to immigration, more open trade policies and flexible product markets limit the benefits of a cheap yen and almost guarantee nonplus growth.

Those conditions compel the European Central Bank and Bank of Japan to keep interest rates near zero and continue purchasing government bonds and private securities. And those push investors in both places to seek foreign alternatives.

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In China, there is market instability, the absence of transparency and limits on foreign participation.

That leave U.S. bonds and stocks as the last, best alternative for private investors, central banks and sovereign wealth funds.

U.S. Treasury data on net capital inflows indicate rising global demand for U.S. government securities and corporate bonds. Consequently, as the Fed slowly pushes up short-term interest rates starting this fall, returns on 10 and 20 years securities will not rise nearly as much — closely mirroring 2004-2006, when the Fed last pushed up short rates.

Currently, the average rate of profits for the S&P 500, which comprises about 80 percent of the publicly-traded U.S. companies by value, is 4.7 percent and that compares favorably with the 2.3 percent paid on 10-year Treasurys.

Even as the Fed raises short-term rates, the above-mentioned factors will drive incoming foreign capital and U.S. investors from long bonds into equities, raising stock prices.

At the same time, long-term sustainable price-earnings ratios for stocks are rising and making U.S. equities cheap.

The shift to a digital economy based on more intellectual capital and less on hard assets like structures and machinery greatly reduces the amount of capital corporate America needs to create valuable products and brands—the foundations of American wealth.

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Google was established with only $25 million in 1999 and grew into a $23 billion enterprise at its initial public offering six years later — the story repeated at ventures like Amazon, Uber and Twitter.

Similarly, as traditional powerhouses like IBM and Ford shift from hardware to more software in the value content of products they sell — and innovations like 3-D printing create flexible manufacturing assets available for new and redesigned products — the demand for private capital is falling.

This is an important reason why established companies are so flush with cash even as they increase investments to improve and expand product offerings, enhance supply chains and invest in promising start-ups.

Lower capital requirements coupled with an abundance of capital, thanks to foreign-capital inflows and flush corporate balance sheets, are pushing down the expected rate of profit (earnings) needed to attract capital into equity investments.

In turn, that pushes up the P/E ratio markets can sustain — even if uncertainties abroad create the wider daily and weekly fluctuations in stock price as recently experienced.

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The S&P 500 Index, as of Friday, was trading at 2126 with a P/E ratio of 21.2. However, the consensus of forecasters indicates the outlook for U.S. growth is strengthening and factoring in expected profits growth over the next 12 months, the P/E ratio falls to 17.9 percent.

That's well below its 25-year average of 19.1.

Assessed against alternative investments and history and given how much more efficiently digital technologies permit businesses to create wealth using investors' cash, stocks are hardly overvalued.

A P/E approaching 25 is reasonable and that could easily push the S&P above 2500.

Commentary by Peter Morici, an economist and business professor at the University of Maryland, and a national columnist. Follow him on Twitter @pmorici1.