Buy Stocks at All-Time Highs

Alexander is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Is it time to chase stocks as they reach ever higher valuations? The stock market has reached new all-time highs, driven by stronger macroeconomic indicators paired with accommodative monetary policy.

The Federal Reserve bellwether

 

Source: FreeStockCharts

For the most part, investors are optimistic and are willing to chase the Dow Jones Industrial Average to record highs. The optimism in stocks is primarily driven by falling costs (process-driven improvements), favorable macroeconomic headwinds, strategic acquisitions or partnerships, business development, and share buy-backs. The five factors are driving both earnings and revenue growth across most sectors.

Investors had been a little guarded on stocks and were worried about the  Federal Reserve’s minutes that were released on July 10. The statements made in the minutes didn’t contradict the Federal Reserve’s statement made on June 18-19. Because of this market, participants probably felt a large surge of relief.

Investors have been anticipating an eventual tapering of quantitative easing, coupled with rising interest rates for quite a while. Investors needed to know the specifics on how and when it would happen. The added detail initially sparked a market correction in both stock and bond market prices.

Bond market a poor investment strategy

Source: YCharts

The SPDR S&P 500 (NYSEMKT: SPY) has been able to recover to all-time highs while bonds have been able to manage a somewhat modest recovery in valuation. It is likely that bond prices will continue to decline going forward, making the iShares Barclays TIPS Bond Fund (NYSEMKT: TIP) a poor performing investment. The primary reason for why an investor would want to avoid a bond ETF is the implied risk associated with the Fed’s bond-purchase programs.

Investors are operating under the assumption that the Federal Reserve will at some point end quantitative easing, and are selling in anticipation of this eventual reality. The reasoning for the bond market sell-off is structural in nature, and is not going to be temporary. Therefore, the average investor shouldn’t attempt buying longer-dated bond notes on dips because it is likely that the bond market will decline even further. The down-trend is well established, and it would take a significant change in Federal Reserve policy in order to turn around the negative sentiment surrounding longer-dated bond securities.

On the other hand, stocks should be able to outperform bonds based on how markets are reacting and the way the tapering effects are going to have an immediate reduction in demand for bonds. This is leading to the assumptions that investors are bidding up the value of stocks with the money that has been cashed out of bonds.

Opportunities

I am most optimistic on stocks. The stock market should be able to sustain higher rates of return for investors. Two pockets of opportunity include technology and financial services. The two are heavily cyclical, but in a cyclical economic recovery the reward may outweigh the risks. To offset some of the risk, I focused on mega caps.

Microsoft (NASDAQ: MSFT) is one of my favorite technology picks right now. This is primarily driven by Office 365 and the amount of growth that could be generated from emerging-market economies. I believe that Citigroup (NYSE: C) has substantial upside going forward. The bank may be able to generate greater rates of growth through its investment banking and asset-management services.

Details on the two companies

Microsoft recently announced a corporate restructuring, which involved a change in the way the company was managed. Investors are optimistic on Microsoft and have been willing to chase the stock to new 52-week highs. I have been an optimist on Microsoft for quite a while as the company offers compelling growth opportunities. The growth is primarily driven by entry-level tablets, which will eventually result in Office 365 purchases. In a previous article, I believe that Microsoft’s primary growth catalyst may come from Office 365, and project that it may eventually contribute $10 billion in added net income by 2017.

Microsoft currently trades at an 18.6 price-to-earnings multiple. The valuation seems reasonable when considering the potential growth in mobile and in Office 365. The company also compensates investors with a 2.58% dividend yield (very generous for a technology company).

Citigroup is one of my favorite financial stocks. For the most part, the company has been able to benefit from declining loan related losses. However, the company’s growth in net income wasn’t driven by falling costs alone. The company was also able to generate an 11% year-over-year gain in revenue. The revenue growth is primarily driven by asset management and investment banking.

A rising stock market will directly translate into ever greater management fees from asset management, and further gains from investment banking. Remember, underwriting activity is likely to go up as companies will have greater incentive to publicly list themselves in a bull market. Analysts are fairly optimistic on the stock, and are willing to project that the company will grow earnings by 14.6% per year over the next five years. The growth is paired with an 18.6 price-to-earnings multiple. The multiple is reasonable when considering the company is expected to grow earnings by 22.5% this year.

Conclusion

I’m primarily a bear on the bond market, and I see no potential of a long-term recovery in bond prices. However, I believe that the stock market should be able to sustain greater rates of appreciation. Because of this, the most logical solution would be to have a greater allocation of stocks.

Citigroup has the benefit of emerging market economies, falling loan losses, along with rising equity values to keep revenue growth at a fairly high pace. Microsoft’s growth will be driven by emerging-market growth, which will translate into greater rates of growth for mobile and Office 365.

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Alexander Cho has no position in any stocks mentioned. The Motley Fool owns shares of Citigroup Inc and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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