US stocks put in a decent return for Q1 2006 even as oil prices settled in at the highs for the quarter, the Federal Reserve continued to raise short term rates, the situation in Iraq improved only modestly, housing prices settled back on falling sales, the 10 year yield moved substantially towards 5%, and President Bush’s approval ratings hit the lows for his presidency. 

Despite this less than stellar economic environment, S&P 500 earnings gained 14.4% for the 4th quarter and 13.5% for 2005.  Growth for Q1 2006 is projected at 11.3%, which would be the 16th consecutive quarter of double digit growth.  Standard and Poors expects that streak to end in Q2, but overall expects growth of 10.8% for 2006.  As we have often pointed out, because 40% of S&P revenues come from overseas operations, the key driver of S&P earnings growth is the state of the overall world economy, which is in pretty good shape right now even if the US economy is taking a bit of a breather after a dozen quarters of above trend growth.  Projecting 10% earnings growth in 2006, with the ten year at 5%, still leaves the S&P 500 undervalued by 15%.

The current bull market dates from August 2002.  From those lows, the S&P 500 gained 67% (though still 15% below the all time highs of March 2000), and the NASDAQ gained 111% (though still 54% below its all time highs.)  In recent months, some market observers have expressed concern that the bull market is aging (3 ½ years!) and that the market is due for a pullback.   As we see below in this chart of the S&P 500 since 1970, a bear market (defined as a pull back of at least 20%, occurs, on average, once every 5 years.  However, since 1974, the average has gained 10%/year (before dividends, about 12%/year including dividends.)  1974 was a pivotal year.  Not only did it include the shock triggered by the 1973 OPEC oil boycott, but that year marked the completion of the transition of the US economy from manufacturing to services.  During that transition, the stock market peaked in 1968 and did not make a new high until 1980 as service companies replaced manufacturing companies in the composition of the index.  As there is no similar transition occurring now, there’s no reason why stocks should plateau for half a generation (as we saw more recently in the Japanese stock market as that economy transitioned from industry to services.