Stocks endure as best house in lousy neighborhood

By Ryan Vlastelica

NEW YORK (Reuters) – In the past six weeks a string of dismaying headlines rocked markets, but you wouldn’t know it to look at U.S. equities now.

The S&P 500 (.SPX: Quote, Profile, Research) is up 26.6 percent from the beginning of September, within striking distance of two-and-a-half-year highs hit in February.

That’s despite a civil war in Libya, the earthquake and tsunami that led to a nuclear crisis in Japan, fears of sovereign debt defaults in Europe, and the specter of a U.S. government shutdown.

Then there is a reeling U.S. housing market and rising gasoline prices that threaten an economic recovery that hasn’t produced strong job growth. Still, the S&P is up 5.6 percent in 2011.

The fact is, with commodities prices soaring and interest rates in various markets still low, the stock market looks like the best house in a bad neighborhood at this point.

Some investors credit undervalued shares for a “Teflon market” that deflects negative news even as daily volume has been near the year’s lows, with action on positive days especially anemic. Others are more wary, believing uprisings in the Middle East and North Africa and events in Japan could spark a sell off down the road.

“The fundamental drivers behind equities remain intact. Corporate balance sheets are healthy, margins are wide and valuations are attractive,” said Joseph Tanious, market strategist at JPMorgan Funds in New York. “Recent events have made me cautious, but I still believe we have room to grow.”

The price-to-earnings ratio for the S&P is 15.54 times trailing 12-month earnings, below a recent five-year average of 16.20, according to Birinyi Associates. The discount suggests stocks could be undervalued despite recent gains.

Equities investors are still more nervous than credit markets, Bank of America-Merrill Lynch analysts said in a recent note.

It compared credit-default swap spreads, a measure of insurance against bond-market default, with the Chicago Board Options Exchange Volatility (.VIX: Quote, Profile, Research), Wall Street’s anxiety gauge, noting a divergence between the two, with the credit markets much more sanguine. But rising inflation could hit bond yields, making them less attractive in coming months.

Fund managers, sensing this, have capitalized by moving into stocks, increasing overall equity exposure in March. (For detail, see ID:nN30152627). The last few months has favored stocks, according to the Investment Company Institute.

“Ever since we saw our first month when inflows favored equities, stocks have been doing well,” said Erick Maronak, chief investment officer at the New York-based Victory Capital Management, which has $35 billion in assets under management. “The flows are signs that while you shouldn’t be 100 percent excited, the picture is brighter.”

WILL EARNINGS TRIP UP EQUITIES?

Pricing in bad news could help buffer stocks against surprises in the upcoming earnings season, when companies detail the impact of higher commodity prices and supply chain disruptions in Japan as a result of the nuclear crisis.

Refiners are expected to be hit by the increase in petroleum prices. Oil service giants Halliburton Co (HAL.N: Quote, Profile, Research) and Schlumberger Ltd (SLB.N: Quote, Profile, Research) have already warned of reduced earnings due to turmoil in the Middle East.

“After these gains, there’s definite risk from oil supply issues and earnings season,” said James Kelleher, director of research at Argus Research Co in New York. “Though I’m bullish on the year, I expect us to retest 1,275 at some point.”

A recent Reuters poll of strategists suggests the market will continue its upward trend, putting the S&P at 1,400 by the end of the year, a level that would mean a gain of 11.3 percent from 2010’s close.

While the market’s endurance could be viewed as a sign of fundamental strength, some see it delaying what they consider to be a necessary consolidation.

While the Vix has returned to its pre-crisis levels, uncertainty in the Arab world and Japan has many believing it could spike again.

“We have an awful lot of hope priced into the market, and that’s usually a dangerous situation,” said Tom Mangan, who helps oversee $2.4 billion as a money manager at James Investment Research Inc in Xenia, Ohio. “I’m surprised the market continues to grind higher with volume as low as it has been; we could be setting ourselves up for a retracement of several hundred points on the Dow (.DJI: Quote, Profile, Research).” (Editing by Andrew Hay).

Stocks endure as best house in lousy neighborhood