Stock bulls face two headwinds now

LAST week, US stocks finished at record highs as a rate cut from the European Central Bank (ECB) and a strong jobs report gave stock bulls a second wind.

The momentum of the latest bull run could carry the market higher for another week. Having closed less than 100 points away, the Dow Jones Industrial Average is almost sure to test the 17,000 level. If they are to run much further, however, the bulls must fight two headwinds: valuation and rising interest rates.

As anticipated, the ECB cut deposit rates for banks below zero, effectively making it cheaper for lenders to give loans than to sit on reserves. This sparked the late-week rally, and the jobs report supported it. A higher-than-forecast 217,000 jobs were added to payrolls in May and the unemployment rate held steady at 6.3 per cent. While the four-month aggregate of jobs added was the highest since the 1990s, what observers such as Dallas Federal Reserve president Richard Fisher have called "structural" problems persist. A low participation rate still shows that millions have been left behind in the recovery.

Sales reports from major retailers last week suggested that the revival of mall traffic in April lasted through May. This week, the government's tally of retail sales should confirm modest growth for the month. In another good sign, a survey of home-builder sentiment is expected to show its highest reading since before the Great Recession.

All this growth may already be "priced in" to stock prices, however. Many market watchers have argued that stocks are "expensive" on a historical basis, opening the valuation debate.

The question of valuation has dogged the stock market all year as investors tried to reconcile the 2013 gains of 30 per cent or more in major indexes with a much slower growth economy. In early March, investors abruptly sold out of the companies whose share prices were the highest relative to their earnings and assets. Companies in fast-growing niches such as biotechnology, social media and 3-D printing rebounded somewhat last week but many are still far from their February highs.

"What we think started it off was people selling (these) high flyers to pay taxes," said David Santschi, chief executive of TrimTabs Investment Research. "You saw selling of growth names in early April was very heavy. After that, there was just a wholesale re-evaluation of (stock prices) in the market."

While pockets of the market remain expensive, it's unclear whether valuations as a whole have reached a peak.

As a general matter, investors should assess the market's valuation by comparing the level of the Standard & Poor's 500 with the aggregate Wall Street earnings estimates for the companies in the index for the year ahead, according to one investment specialist. That's known as the price-to-earnings ratio and can be compared with historical levels.

The broad S&P 500 is trading at about 16 times estimated earnings for the full year 2014, according to The Wall Street Journal. This is more or less in line with the historical average and nowhere near the inflated prices of the late 1990s, when the S&P 500 traded at more than 30 times a comparable tally.

The stronger jobs data effectively ends all hope the Fed would reverse its retreat from monetary stimulus. The Fed is almost halfway through its gradual "tapering" of purchases, which is on track to finish at the end of this year.

Typically growth in the economy, corporate earnings and stock prices is accompanied by a rise in interest rates - particularly when the Fed is close to hiking rates, the logical next step in its policy.