Why Stocks Look So Attractive Now

Historically, December is a seasonally strong period for U.S. stocks. But, so far, 2011 has not been cooperating with familiar seasonal patterns. The most notable being the failure of U.S.major stock market indices, namely the Dow Jones Industrial Average and the S&P 500, to rally in a Presidential pre-election year.

With only two weeks left in 2011, all indications are that the year-end rally will likely be a no show this year. But this is not bad news. In fact, it could be a prelude to good news for both the Dow Jones Industrial Average and the S&P 500.

The list of bearish economic, financial and political developments making the headlines is long, formidable and well-known. Instead of being discounted by stocks, by a display of the famous ability of stocks “to climb the wall of worry,” most of the global markets have been sinking.

The commodities have also joined the slide. Even gold, the asset gold bugs regard as a safe haven during times of crisis, has taken a 17% hit over the last three months. Instead, the much-maligned U.S. dollar has recently taken over the role of refuge of last resort for big money.

The flight to U.S. dollars has added further strength to U.S. treasuries, with yields on long-term treasuries declining to new 70-year lows, and with the yield on 10-year inflation protected treasuries (TIPS) dropping below 0%! Yes, that’s zero percent!

It also appears that some cash has also found refuge in U.S.stocks, helping to make the Dow Jones Industrial Average and S&P 500 the top global performers this year when compared to other major world stock indices.

With only two weeks left to go in 2011, the Dow Jones Industrial Average is up 2.7% for 2011 and the S&P 500 is down only three percent on the year. That compares favorably with losses in Toronto (of 13.4%),Shanghai (of 20.7%),Tokyo (of 18.7%), Frankfurt (of 17.2%),Paris (of 22.4%) and London (of 8.7%).

Looking for more rational reasons behind the relative resiliency of U.S. stocks other than the inflow of panic-stricken money, I could come up with only two valid arguments.

The first being the widening undervaluation of stocks relative to fixed-interest-bearing securities. The second is the continuing strength of U.S. corporate earnings. Taking the technical approach to the fundamental bread and butter data, I have plotted quarterly U.S. corporate earnings versus the average quarterly price of the Dow Jones Industrial Average.

As the 20-year chart shows below, on this basis, reversals in profits have led major reversals in the Dow Jones Industrial Average. Furthermore, as long as profits trended up, the Dow Jones Industrial Average did not suffer any major setback. This is heresy to believers in the much widely accepted hypothesis of the stock market being the leading indicator to the economy and corporate profits.

why stocks look so attractive now

The chart, updated to the quarter ended September 2011, is currently the most bullish chart in my keep and the main rationale for continuing relative strength of the U.S.market.

As long as corporate earnings keep rising in 2012, and so far there is no firm evidence they won’t, the Dow Jones Industrial Average and S&P 500 stocks will rise in 2012 with corporate earnings.