Don't Sweat the Dip: Stocks Could Soon Hit New Highs

Don't feel like a dip if you missed buying the dip. The Dow took a 1,000-point round trip in just the last week, and the tug of war between the V-shaped recovery in corporate profits and Continental credit fears promises plenty more volatility to come. But after a peak-to-trough drop in the S&P 500 ($INX) that came oh-so-close to a full-blown 10% correction, the next major move for stocks looks to be back up.

After all, pullbacks are just a natural part of how the market works its way higher, says Jeffrey Kleintop, chief market strategist at LPL Financial.

"The pullbacks cleanse the excesses that build up during a rally," Kleintop wrote in a Monday note to clients. "They impose discipline by punishing speculation, rewarding value, and realigning expectations." Most important, Kleintop says, a pullback creates a solid basis of support on which the stock market may continue to advance.

Right in Line With the Five-Year Average

It's not that stocks look particularly cheap these days (and the market appears to be running more on technicals than on fundamentals, anyway), but neither do they look overpriced. That's especially true when considering the premiums risk-hungry investors have shown themselves willing to pay for stocks throughout the rally.

Last week's sell-off had the S&P 500 trading at a forward price-to-earnings (P/E) multiple of 13.8, according to Bloomberg data. That's the cheapest stocks have been since March 2009, also known as the bottom of the bear market. Cut to today, and after a nice rebound, stocks are trading essentially in line with their five-year average forward P/E (about 14.2).

That sounds pretty ho-hum, but here's the kicker: When global investors have chased risk during the rally, they've pushed the forward P/E on the S&P 500 above 18 (at its peak around Christmas 2009), and they were recently forking over more than 15 times forward earnings. That means risk-chasing investors have shown a great willingness to pay much fatter premiums for stocks as recently as last week.

That's called multiple expansion, and it has nifty implications for share prices. For example, if the S&P 500 went from its current multiple to 16 times forward earnings (hardly a lofty premium at all), it would stand at nearly 1,300 -- almost 11% higher than it is now -- or the equivalent of Dow 11,900.

Familiar Pattern

It's also somewhat reassuring to see that the market has been stuck in a sort of wash, rinse and repeat cycle for three consecutive quarters. Take a look at this chart, below, courtesy of LPL Financial, which shows the S&P 500's trajectory over the last three quarters.

In the last two quarters, the market started off by embracing risk in light of better-than-expected corporate earnings and encouraging signs of economic recovery. Then some event -- be it health care reform, Chinese credit tightening or sovereign debt fears -- shook investor sentiment and spooked speculators out of their riskier positions.

The beginning of this quarter appears in line with the trends in the last two, which could indicate that a climb is again in order. After a 5% to 10% pullback, Kleintop says investors now have an attractive opportunity to buy more stocks.

"While investors last week focused on the few burning trees, the health and sustainability of the overall forest continues to improve, with attractive valuations, above-average economic and profit growth, low interest rates and the return of job growth," Kleintop writes.

Not that it's likely to be a smooth ride. In the words of Jason Weisberg, a trader with Seaport Securities, the market wants to "languish higher." But up is better than down, no matter how we get there. If the recent pullback is over and we really are about to experience deja vu all over again, the market could be setting new highs in a matter of weeks.