(Bloomberg) -- Craig Hodges, who runs one of the best-performing U.S. mutual funds, is preparing for the next leg of America’s almost five-year-old bull market.
After his holdings of Yelp Inc. and Pandora Media Inc. doubled earlier this year, the 50-year-old manager is adding a new stock: Gogo Inc., an unprofitable provider of in-flight Wi- Fi that’s up 63 percent since its June public offering.
“We’ve got another two or three years of a good stock market,” said Hodges, whose Dallas-based Hodges Fund is beating 99 percent of its peers with an increase of 55 percent. “We’re coming up with new areas all the time. When things get crazily stretched, there are new emerging names out there to get in.”
While the Standard & Poor’s 500 Index is poised for its biggest annual rally in 15 years, indicators from transportation stocks to the number of companies reaching 52-week highs to the rally’s breadth are at levels that signaled further gains in the past. Even price-earnings ratios, up about 20 percent this year, remain below valuations that preceded the end to previous bull markets.
Since 2009, skeptics have said equities would decline, first because the credit crisis had killed the economy, and now because investors have become too enthusiastic for their own good. BlackRock Inc.’s Laurence Fink and Doug Kass at Seabreeze Partners Management Inc. said this month that stocks were headed for losses after an almost uninterrupted rally that lifted the S&P 500 in one of its broadest advances on record.
Glee, Gloom
To James Paulsen at Wells Capital Management Inc., the prospect of a tumble remains a longshot.
“Confidence is still barely average by historic standards,” the Minneapolis-based chief investment strategist at Wells Capital, which oversees about $340 billion, said in a phone interview. “The market is up big because for a long time we priced the financial markets for the end of the world. And really all that’s happened so far is we found out the world isn’t going to end.”
The S&P 500 climbed 0.4 percent to 1,804.76 last week, extending the 2013 gain to 27 percent, as the pace of hiring increased. The index surpassed 1,800 for the first time and is up 167 percent since March 2009, as Federal Reserve Chairman Ben S. Bernanke held rates near zero and initiated three rounds of bond purchases to stimulate the economy. S&P 500 futures expiring next month climbed 0.3 percent at 11:17 a.m. in London.
Confirmation Theory
Rallies in shares of smaller companies, banks and transportation stocks have been bullish signs in the past. During the four biggest bull markets of the last quarter century, peaks in those categories have come before the S&P 500 reached its highest level almost 90 percent of the time, data compiled by Bloomberg show.
The Russell 2000 Index of companies with an average market value of less than $1 billion reached an all-time high of 1,124.92 on Nov. 22. The S&P 500 Financials Index climbed last week to the highest point since September 2008. Indexes of transportation stocks and companies whose earnings are most dependent on economic growth reached records this month.
“Railroads in particular are quite sensitive to the economy, most of the smaller-cap companies have a more domestic business, and the smaller and regional banks tend to be more focused on lending to consumers and businesses,” John Carey, a portfolio manager at Pioneer Investment Management who oversees about $200 billion, said in a Nov. 21 phone interview. “As they prosper, the rest of the country will prosper.”
Earnings Multiples
Valuations in the S&P 500 climbed 20 percent in 2013 as more than 440 stocks in the gauge advanced. Even with the expansion, the price-earnings ratio, at about 19, remains 19 percent below the average level at which bull markets ended since 1982, according to data compiled by S&P and Bloomberg. The index traded at more than 30 times earnings when stocks plunged in 2000 and at 21 in 1987.
“It’s still a buy-on-the-dips equity market,” Terry Sandven, chief equity strategist at U.S. Bank Wealth Management, said in a phone interview from Minneapolis. He helps oversee $112 billion. “Inflation is contained, sentiment is still generally positive, and valuation is in that fair camp.”
Netflix Inc., Best Buy Co. and Micron Technology Inc. led the S&P 500 in 2013, climbing more than 200 percent since January, data compiled by Bloomberg show. They’re among more than 190 companies reaching 52-week highs this year.
Stock gains continue for another 22 months after a peak in the number of companies setting new highs, according to the average in the last three bull markets. In the last rally, 121 stocks traded at highs on Nov. 3, 2003, the most for any day during that cycle, and the index rose 48 percent through 2007. The S&P 500 climbed 33 percent in the 13 months after 177 companies set records in June 1997.
Retail Investors
“Rising markets attract attention and focus,” said Paul Zemsky, the New York-based head of asset allocation at ING Investment Management which oversees $190 billion. “People want to participate and be part of the crowd.”
Individual investors are just now coming back to the equity market, sending about $27.1 billion to stock managers in 2013. The deposits would make this year the first since 2006 that equity funds have seen net inflows, after almost $400 billion was withdrawn the previous four years, according to data compiled by the Washington-based Investment Companies Institute.
Stocks have climbed after flows turned positive in the past, according to ICI data going back to 1984. Investors added $6.8 billion to the funds in 1989 after taking out almost $15 billion in 1988. The S&P 500 started its biggest bull market on record in 1990, as inflows doubled that year. Flows turned positive in 2003, when deposits totaled $144 billion, and the S&P 500 kept climbing until October 2007.
Share Demand
“Retail investors are shifting into equities,” Lawrence Creatura, a Rochester, New York-based fund manager at Federated Investors Inc., which oversees $367 billion, said by phone. “It certainly bolsters the chance for stocks to continue to rise. It is a source of demand for shares.”
This year’s 27 percent advance has gone almost uninterrupted, leading Fink and Kass to question the sustainability of the rally. The 25 months since the S&P 500’s last 10 percent drop is the longest stretch without such a decline since 2007, according to S&P.
Gains have pushed the S&P 500 to a record 1,804.76 this year, more than 15 percent above the high set in October 2007, data compiled by Bloomberg show. That’s come even as profit growth slowed this year and economists cut growth projections.
“Traders and investors, strategists and pundits are now almost historically complacent,” Kass, the founder of Palm Beach, Florida-based Seabreeze, said in a Nov. 12 Bloomberg Radio interview with Tom Keene and Michael McKee. “They’re glib.”
Going Short
Kass has grown more bearish on the S&P 500 since he said a year ago that fears were overblown and called for the S&P 500 to rise to a record. “I have more than one foot out the door and I’m looking for short opportunities,” he said this month.
Stocks may decline as much as 15 percent because of political risks in China, Japan, France and the U.S., according to Fink, whose New York-based BlackRock is the world’s largest money manager with $4.1 trillion in assets. Last year Fink said he would invest all of his personal wealth in equities.
The steady surge isn’t reason enough to worry about a correction, according to BMO Capital Markets. There have been 17 pullbacks of at least 5 percent since the rally started 4 1/2 years ago, in line with the average 15 times for bull markets since 1970, according to data compiled by BMO.
Pessimistic Fuel
“There’s clearly a lot of suspicion and doubt in this bull market, and that in and of itself gives it further fuel,” Rich Weiss, the Mountain View, California-based senior portfolio manager for American Century Investment who helps oversee $130 billion, said by phone Nov. 21. “Not everybody is in. The level of exuberance can clearly grow.”
While the rally has lasted about six months longer and produced bigger gains than the average bull market since World War II, the number of stocks climbing this year is bullish. History shows that widespread stock advances one year have led to an S&P 500 rally the next. In the six times when at least 400 stocks posted increases since 1980, the index returned an average 14 percent in the following year, according to Strategas Research Partners. All of those ensuing years were positive.
Analysts project earnings will expand 10 percent next year and 11 percent in 2015, doubling the 2013 growth rate, according to data compiled by Bloomberg. At the same time, the pace of economic expansion will increase through September 2014.
Hodges said he sold Yelp, which is unprofitable, and Pandora, which trades at 261 times estimated earnings, after their valuations got beyond his comfort level. Since September, he’s invested in Gogo, based in Itasca, Illinois, and online video advertising company Tremor Video Inc. Analysts say both will lose money next year.
“There’s many segments of the market that are very undervalued and have great potential from here,” Hodges said. “Overall, I don’t see excesses.”
