I've been doing a number of interviews recently, and the one thing everyone wants to talk about is the new records being set by the market. With the S&P 500 touching 1,800 and the Dow touching 16,000, the question is whether this is the start of another upward run or whether it marks the peak.
There's something about round numbers that gets people going. The end of the world in 2000, the hype over Dow 10,000 (both ways), and the repeated questions at every 1,000 mark suggest that somehow this number is different.
I wrote back in March about stock price records, noting that stock prices ultimately have to be driven by earnings. At the time, prices and earnings were pretty closely related, per the chart below. I said then that whether the rally was sustainable depended on either continued growth in earnings or a willingness to pay more for existing earnings.
Click to enlargeEight months later, this chart is worth another look. Below, we can clearly see that, while prices have continued to rise, profits have started to roll over, and the red line has cracked the blue line. I ran this chart over a longer period, for 20 years, to get a historical perspective on the relationship between earnings and price growth, selecting that time frame to reflect both bull and bear markets.
Click to enlargeClearly, stock prices have been growing faster than earnings over the past five years. This is not necessarily bad, and it is sustainable over a period of years. (See the period from 1993 through 2000, and from 2002 through 2007.) Note, however, that at some point during both of those periods, prices corrected to below the earnings line. That correction occurred-again, in both cases-as earnings started to decline after growing for years. Sustained earnings growth led to higher levels of sustained price growth, but declines in earnings led, with a lag, to declines in prices. None of this is actually very surprising, but it provides context for the present.
Let's assume, for argument's sake, that the market is currently fairly valued. This says nothing about whether it will continue to appreciate. In fact, if the market is currently fairly valued, then any appreciation depends on it becoming expensive. Much of the argument for continued price appreciation comes from the notion that earnings growth will bear out current high multiples.
There are a few implicit assumptions behind this notion. First is that the U.S. economy will continue to grow, which I agree with. Second is that current low interest rates and Federal Reserve support will continue for the indefinite future. That may well be the case, but it is inconsistent with the notion of a growing U.S. economy. The question then will become whether the greater-than-expected improvement in one can offset any change in the other. At this point, the market seems to expect both.
Third, given that inconsistency, is that current profit margins will continue to improve, giving companies greater EPS growth than revenue growth. Again, this is possible, but inconsistent with a growing U.S. economy-which requires greater wage growth, which will come directly off companies' bottom lines. We are likely, over time, to have one or the other but not both.
I've been arguing that the market has made a transition from a fundamental, earnings-driven rally to a psychologically based rally, and the proof of that is the multiple expansion we have seen. Retail investors are starting to worry more about missing out on the rally than about losing money, which is a troubling sign. Any rally based on psychology is very vulnerable to a change in that psychology. When debt is introduced-and I've written before about the record-high levels of margin debt-the situation becomes even trickier.
None of this is to say a correction is imminent. Most market participants now expect the market to rally through the end of the year, which may become a self-fulfilling prophecy. If retail investors really do return in a big way, they could drive the market much higher. Investors need to be aware of that.
They also need to be aware, however, that many conditions that characterized previous market tops are moving into position. Margin debt, the price line crossing the earnings line, and others are all signs to be concerned.
Ironically, the biggest sign we're probably not in a bubble is all of the headlines asking if we're in a bubble. As long as many people are very worried, the disconnection that bubbles depend on probably hasn't taken hold. What we do know, though, is that if we aren't in a full-blown bubble now, we're at least on the beginning of that road.