The massive rally of the stock market since March 2009 has been perplexing for many, but the state of confusion has reached new heights as the stock market has surged another 2.0% in May, surpassing the Dow 15,000 index milestone and hovering near all-time record highs. Over the last few weeks, the volume of questions and tone of disbelief emanating from my social circles has become deafening. Here are some of the questions and comments I’ve received lately:
'Why in the heck is the market up so much?'
'This market makes absolutely no sense!'
'Why should I buy at the peak when I can buy at the bottom?'
'With all this bad news, when is the stock market going to go down?'
'You must be shorting (betting against) this market, right?'
With the stock market up about 14% in 2013, as measured by the S&P 500 index (on top of another 13% increase in 2012), bystanders have frustratingly watched stock prices rise about 150% from the 2009 lows. Those investors who appropriately controlled risk in their diversified portfolios and did not panic in 2008-09 have been handsomely rewarded for their patience. Those individuals who have had their money stuffed under the mattress in savings accounts, money markets, CDs, and low-yielding bonds have continued to watch inflation eat away at their wealth. If the investing bystanders make no changes to their portfolios, inflationary and interest risks could outweigh the unlikely potential of Armageddon. Overly nervous investors will have to wait generations for the paltry 0.2% bank rates to equalize the equity market returns earned thus far.
For years I have been listening to the skeptics calling for a purported artificially inflated stock market to crash. When prices continued to more than double over the last few years, the doubters blamed Ben Bernanke and the Federal Reserve as the instigators. The bears continue to point fingers at the Federal Reserve for spiking the financial punch bowl with unnaturally low interest rates (through quantitative easing bond purchases), thereby laying the foundation for a looming, inevitable market crash. So far, the boogeyman is still hiding. If all the concerns about the Benghazi tragedy, IRS conservative targeting, and Federal Reserve bond "tapering" are warranted, then it raises the question: "How can the Dow Jones and other indexes be setting new all-time highs?"
In short, here are a few reasons:
1. Record Profits:
Source: Calafia Beach Pundit.
You hear a lot of noise on TV and read a lot of blathering in newspapers/blogs, but what you don't hear much about is how corporate profits have about tripled since the year 2000 (see red line in chart above), and how the profit recovery from the recent recession has been the strongest in 55 years (as per Scott Grannis). The profit collapse during the Great Recession was closely chronicled in nail-biting detail, but a boring profit recovery story sells a lot less media advertising and therefore gets swept under the rug.
2. Reasonable Prices (Comparing Apples and Oranges):
Source: Dr. Ed's Blog.
The price/earnings ratio (P/E) is a general barometer of stock price levels, and as you can see from the chart above (from Ed Yardeni), current stock price levels are near the historical average of 13.7x -- not at frothy levels experienced during the late 1990s and early 2000s.
Comparing Apples and Oranges
At the most basic level of analysis, investors are like farmers who choose between apples (stocks) and oranges (bonds). On the investment farm, growers are generally going to pick the fruit that generates the largest harvest and provide the best return. Stocks (apples) have historically offered the best prices and yielded the best harvests over longer periods of time, but unfortunately stocks (apples) also have wild swings in annual production compared to the historically steady crop of bonds (oranges). The disastrous apple crop of 2008-09 led a massive group of farmers to flood into buying a stable supply of oranges (bonds). Unfortunately the price of growing oranges (i.e., buying bonds) has grown to the highest levels in a generation, with crop yields (interest rates) also at a generational low. Even though I strongly believe apples (stocks) currently offer a better long-term profit potential, I continue to remind every farmer (investor) that their own personal situation is unique, and therefore they should not be overly concentrated in either apples (stocks) or oranges (bonds).
Source: Dr. Ed's Blog.
Regardless, you can see from the chart above (from Dr. Ed's Blog), the red line (stocks) is yielding substantially more than the blue line (bonds) -- around 7% vs. 2%. The key for every investor is to discover an optimal balance of apples (stocks) and oranges (bonds) that meets personal objectives and constraints.
3. Skepticism (Market Climbs a Wall of Worry):
Source: Calafia Beach Pundit.
Although corporate profits are strong, and equity prices are reasonably priced, investors have been withdrawing hundreds of billions of dollars from equity funds (negative blue lines in chart above, from Calafia Beach Pundit). While the panic of 2008-09 has been extinguished from average investors' psyches, the Recession in Europe, slowing growth in China, Washington gridlock, and the fresh memories of the U.S. financial crisis have created a palpable, nervous skepticism. Most recently, investors were bombarded with the mantra of "Sell in May and go away" -- so far, that advice hasn’t worked so well. To buttress my point about this underlying skepticism, one need not look any further than a recent CNBC segment titled, "The Most Confusing Market Ever" (click the image below to view the video).
It's clear that investors remain skittish, but as legendary investor Sir John Templeton so aptly stated, "Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria." The sentiment pendulum has been swinging in the right direction (see a prior Investing Caffeine article), but when money flows sustainably into equities and optimism/euphoria rules the day, then I will become much more fearful.
Being a successful investor or a farmer is a tough job. I'll stop growing apples when my overly optimistic customers beg for more apples, and yields on oranges also improve. In the meantime, investors need to remember that no matter how confusing the market is, don't put all your oranges (bonds) or apples (stocks) in one basket (portfolio) because the financial markets do not need to get any crazier than they are already.
Disclosure: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision.