Russell Investments Blog

Equity markets ran hard in the first quarter. The Russell 1000® Index was up 12.9 percent in the quarter, while the Russell Developed Large Cap Index and the Russell Emerging Markets Index were up net 11.75 percent and 14.65 percent, respectively. As of March 31, 2012, all of these indexes were up more than 25 percent from their 52-week lows in October 2011.

That is a heck of a run and many investors are sensibly asking where do we go from here? Can stocks go up from here and how likely is that? In order to answer these questions you need to frame them appropriately. The simplified framework I offer is in the answering of three questions:

1. What has the market already priced into in recently very good performance?
2. What would be the primary driver to a further increase in stock prices?
3. How likely is that?

What has the market priced into stocks?
No one can ever know precisely what the market has priced into it, but you can make some reasonable deductions. Our market expectation is that the three major factors that have driven global economic and market expectations since the beginning of the economic and market recovery starting in 2009 remain the areas of greatest market focus, namely:

1. The sustainability of the U.S. economic recovery
2. Europe
3. China

In terms of stock prices, we believe that current market levels reflect fair value in the following scenario:

1. The U.S. recovery is sustainable and very mediocre, consensus at 2.5 percent to 3 percent GDP growth in 2012
2. Europe is in the middle of a relatively moderate recession, with core Europe in a mild recession and the peripheral countries experiencing depression-like conditions.
3. China’s growth rate will be near the consensus 8 percent to 8.5 percent range

What would be the primary driver for higher stock prices?
Simply put, further multiple expansion will be the primary driver for higher stock prices.

It’s easy to say, but what does that mean? The global corporate earnings recovery since 2009 has been nothing short of spectacular, but we believe we are well past the point of peak earnings growth in this market cycle. Broadly, margins are at all-time highs and operational productivity leverage is largely played out. This means that future earnings growth will likely be hard yards to gain in the next few years.

How individual companies manage this will have a great deal of impact on their individual stock prices, which, incidentally, will likely lead to a continuation of the positive stock-picking active management environment that we’ve seen this year. More to the point of this conversation however, it’s likely that companies will have to hire more people to create the incremental goods and services necessary to grow.

An increase in employment creates greater confidence in the sustainability – dare we say expansion? – of economic recovery, which in turn leads people to lengthen the timeframe used to assess potential investments. Investors typically become more willing to assign greater value to future expected corporate earnings one, two or three years into the future. Because they expect economic stability, they are more confident that companies will actual achieve expected earnings in 2012 and 2013.

This virtuous circle creates the conditions for multiple, price/earnings (P/E), expansions, which are simply the price that market is willing to pay for a unit of earnings. If the market expects that future earnings growth is more likely now than before, it will likely pay a higher price for the stock. This phenomenon effectively explains why equity markets generally continue to go up even after earnings growth starts to decline. If this is what we see, it will likely lead to modest multiple expansion.

So how likely is this to occur? That’s the $64,000 question, isn’t it? I’ll try to answer that question in tomorrow’s blog post.