How much higher can stocks go?

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CNBC video

How high can stocks go?
May 30 – CNBC talks to a roundtable of market watchers about the outlook for further gains by the U.S. stock market.

CNBC

Market update

Data: MSN Money and ComStock

Strong growth abroad has generated cash looking for a place to invest. Some of that cash comes from interest payments on U.S. debt, some from profits on goods exported to the U.S. So overseas investors have been moving that cash back into U.S.

A weak dollar has also attracted cash to U.S. financial markets as overseas investors go bargain hunting. As the dollar goes down, their euros and yen go farther when they buy dollar-denominated assets.

“That is a substantial force, and it’s becomeing an increasingly bigger force," said Hugh Johnson, chairman of Johnson Illington Advisors. “So international capital flows are a big part of this whole process.”

One reason capital is flowing to the U.S. stock market is that it's the largest in the world. Of the $43.6 trillion total value of listed companies worldwide, roughly $17 trillion — or about 40 percent is made up of U.S. companies, according to the latest figures available from the World Bank. Foreign investors are even getting into the U.S. private equity game. Earlier this month, China's state investment company said it was investing $3 billion in Blackstone Group, the second-largest U.S. private equity firm.

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Despite the economic slowdown, the profits of U.S. companies continue to hold up relatively well — thanks again to stable interest rates. First-quarter profit gains for companies in the S&P 500 fell just shy of double digit-growth. But the gains were roughly double what many Wall Street analysts had expected.

Because investors who buy stocks today do so based on expectations of higher future earnings, much of the current buying is based on the widely held view that the U.S. economy will dodge a recession before growth begins to pick up at the beginning of next year. To get in on that hoped-for pick-up in business activity, investors are laying down their bets today.

Even with the recent surge in stocks, the prices investors are paying — relatively to corporate earnings — are not all that high by historical standards.

“The valuations are little a bit high, but this is not 1999-2000,” said Johnson, “Valuations are not at speculative levels.”

In fact, stock investors are paying substantially less for each dollar of earnings than they were at the 2000 market peak. If the stocks that make up the S&P 500 index were selling at the same price-to-earnings ratio as they were in March 2000, the index would now stand at 2,594 — instead of Wednesday's close of 1,527, according to S&P analyst Howard Silverblatt.

But current stock prices are based on expectations that the U.S. economy will pick up next year — and that interest rates will remain low. A rise in rates could quickly throw cold water on the market’s hot streak.

Higher rates would hurt in two ways. First, they would make Treasury bonds look more attractive: Why risk your money on stocks when bonds offer a solid return? That would divert some of the incoming cash stream away from the stock market.

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A rise in interest rates would also make it more expensive for companies to carry debt on their books, taking a bite out of profits. And it would raise the cost of borrowing to fund acquisitions.

So far, much of the stock buying has been coming from professional investors. But if the market continues to rise, some analysts expect a pickup in buying from individual investors.

“We think the public will come back,” said Don Hays, president of Hays Advisory. “We're all talking about private equity, but the public has more money than private equity, believe it or not. That money is way on the sidelines."

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