4 Reasons the Stock Market Has Doubled

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 |  About: SPDR S&P 500 Trust ETF (SPY)
by: David Van Knapp

In a little less than two years, beginning March 10, 2009, the stock market has just about doubled. Using the S&P 500 as a proxy, it has gone from 677 to 1332 (+97%). SPY, an ETF that tracks the S&P 500, has gone from 68.11 to 133.43 (+96%). If one were to include dividends (about 2% per year), the market is just about at the +100% mark over the last 23 months.

It might be instructive to consider why that has happened. Here are my four chief reasons.

SPY: The Two-Year Doubling

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Source: StockCharts, accessed 2/12/2011. Click to enlarge images.

Note: Candlesticks (periods) are weekly, not daily. MA(10)—the blue line—corresponds to about a 50-day moving average. MA(40)—the red line—corresponds to about a 200-day moving average.

1. All the Stimulus / Fed Money Worked; the Recession Ended

Don’t fight the Fed. Between TARP, TALF, PPIP, QE, industry bailouts, the recent tax compromise, and the like, a tremendous amount of governmental money has been made available to ease the financial crisis and combat the recession. The Fed has held interest rates near zero since December 2008.

The combination of hundreds of billions of dollars in direct or indirect stimulus, plus sustained near-zero interest rates, have had predictable effects on the stock market: It has gone up.

The obvious and pervasive government influence has led many pundits to call the bull market that began on March 9, 2009 “fake” or “rigged.” Investments in stocks have been criticized as speculative, unsustainable, and sure to end badly. Nevertheless, whether you believe that the stock market rally is legitimate or not, you cannot convert that into an accurate statement that the rally never happened, nor that investors who profited from have been suckers or foolish.

According to the National Bureau of Economic Research (NBER), which enjoys quasi-official status in dating recessions, the recession that began in December, 2007, ended in June, 2009. That is underscored by the GDP numbers in the table below, which show that after several quarters of decline, GDP growth turned positive in Q3 2009 and has remained positive since then.

Real GDP: Percent Change from Previous Period

2008-III

IV

2009-I

II

III

IV

2010-I

I

III

IV

-4.0

-6.8

-4.9

-0.7

1.6

5.0

3.7

1.7

2.6

3.2

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Source: Bureau of Economic Analysis, News Release 1/28/2011

2. The Market Climbed a Wall of Worry

Per Investopedia, a wall of worry is a bullish market trend occurring in the face of negative uncertainties. That certainly describes this bull market. Judging from the many negative articles and comments since the rally began, this bull market has climbed one of the steepest walls of worry on record, so strong that it led many investors to continually bet against it. Except for brief interruptions, they have been repeatedly on the wrong side of the trade.

The VIX (ChicagoBoard Options Exchange Market Volatility Index) is used extensively in behavioral finance as a proxy for investor sentiment. It is often referred to as the “fear index.” The VIX measures implied or expected volatility of S&P 500 options over the next 30 days.High levels in the VIX, so the interpretation goes, indicate that investors have pessimistic expectations about the U.S. stock market. Readings in the high 20’s, and certainly over 30, are usually interpreted as a high level of fear, corresponding to a higher likelihood of a market decline.

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Source: StockCharts, accessed 2/13/2011. Note: Bars (periods) are weekly, not daily.

As you can see from the chart, VIX levels have declined steadily—with one exception— since the market rally began two years ago. The VIX declined into the teens by last May (14 months into the rally), then shot up during the correction last May-June. This was a period during which certain indexes of leading economic indicators—such as the widely followed ECRI weekly and Conference Board monthly indexes—faltered in their steady upward movements since early 2010, leading many to predict a double-dip recession (an interpretation that ECRI, for one, consistently said was incorrect).

But the leading economic indicators resumed their positive gains, no double-dip recession occurred, and following the correction, the VIX settled back into the 20’s and more recently the teens.

Since early December, the market has been almost preternaturally lacking in volatility. The S&P 500 has had only four daily gains or losses of 1% or more. In that time, the index has gone up about 8%. AAII’s weekly survey and other sentiment measures indicate that both individual and institutional investors are bullish.

3. The Market Was Undervalued

One of my favorite measures of market valuation is Morningstar’s Market Valuation Graph. It represents a simple ratio of the prices of the 1800-or-so stocks that Morningstar covers to the “fair” prices that its analysts compute for those stocks (using a discounted cash-flow methodology). Being independent, I place more credence in Morningstar’s fair values than in those of brokerage analysts. Plus this approach is forward-looking. In Morningstar’s graph, a ratio of 1.00 indicates a fairly valued market.

Morningstar Market Valuation Graph

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Source: Morningstar Market Valuation Graph accessed 2/12/2011.

As you can see, Morningstar had the market significantly (45%) undervalued by the end of 2008. It improved briefly in early 2009, then fell back again until the two-year rally started in March, 2009. The market reached fair valuation by mid-2009, and since then it has meandered back and forth between slightly overvalued and slightly undervalued, never by more than 10% in either direction.

In contrast to Morningstar’s approach, which is forward-looking, the widely used P/E measure of valuation looks backwards. The following table shows S&P’s measures of P/E for its own index from the end of 2008 to the present, plus projections for 2011 and 2012.

S&P 500’s P/E and As-Reported Earnings

AS-REPORTED

12 MONTH AS-

EARNINGS

REPORTED

P/E

EARNINGS

DATE

S&P 500 VALUE

PER SHR

ESTIMATES

2012 estimate

14.93

$88.48

2011 estimate

15.10

$87.46

2010 estimate (80%)

1257.64

17.19

$76.86

ACTUALS

09/30/2010

1141.20

15.88

$71.86

06/30/2010

1030.71

15.36

$67.10

03/31/2010

1169.43

19.19

$60.93

12/31/2009

1115.10

21.88

$50.97

09/30/2009

1057.08

84.30

$12.54

06/30/2009

919.32

122.41

$7.51

03/30/2009

797.87

116.31

$6.86

03/09/2009

676.53

12/31/2008

903.25

60.70

$14.88

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Source: S&P Market Attributes, Earnings and Estimates Report, accessed 2/12/2011.

Note: All P/E and Earnings values are for the trailing 12 months, not for the individual quarter itself.

If you were using these P/E numbers to gauge market valuation, you would have never thought that the market was undervalued. Many investors, in fact, called the market “absurdly overvalued” for many months into its rally.

But they missed a key fact: The S&P 500’s P/E, being backwards-looking, reached so high in 2009 simply because S&P trailing earnings dropped so low. (Earnings registered as negative in Q4 2008, the first and only time this has happened in the history of the index, I believe.) In this case, trailing earnings were not predictive of future earnings, as can be seen from the last column. From the final quarter of 2008, the as-reported earnings for the S&P 500 have more than quintupled according to S&P’s own estimates (the final numbers for 2010 are not in yet). Given the five-fold increase in annual earnings, it is not surprising that the market has doubled. The market correctly predicted the turnaround in corporate profits.

4. Low Volume Didn’t Matter

Throughout the rally, it has been criticized as not being confirmed by high volume. In technical analysis, market volume is often considered an important indicator in determining the strength or validity of a price move. During the rally, the lack of volume has frequently been used to question up moves of particular days, weeks, or longer periods of time.

NYSE Group Volume Records - Top 10 Quarters

Rank

Quarter Ending Date

NYSE Group Volume in All Issues Traded

Trading Days

1

12/31/2008

231,709,829,419

64

2

3/31/2009

219,065,726,144

61

3

9/30/2008

208,947,123,881

64

4

6/30/2009

204,495,834,486

63

5

3/31/2008

194,080,565,699

61

6

6/30/2010

186,150,353,049

63

7

9/28/2007

178,386,977,698

63

8

6/30/2008

167,184,236,176

64

9

9/30/2009

166,303,224,165

64

10

12/31/2007

163,683,733,699

64

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Source: NYSE Euronext, NYSE Statistics Archive, accessed 2/14/2011.

The facts don’t seem to support the criticisms. The table above shows the top ten quarters, of all-time, in trading volume on the NYSE and related exchanges. Quarters numbered 2, 4, 6, and 9 all occurred during the rally period and are members of the Top 10. They would seem to help “confirm” the rally. (Note also that the four quarters of 2008 all fall in the Top 10 as well, “confirming” the vicious bear market of that year.)

Look back at the beginning of this article, at the chart of SPY during the two-year rally. The highest-volume weeks are mostly down weeks. But we know that they occurred during the two-year market doubling. It would seem that trading volume has been a meaningless statistic throughout this rally.

Where to From Here?

In doubling, I believe that the market has more or less accurately dealt with the inputs available to it over the past two years. The market started from a position of being significantly undervalued, and for a variety of reasons, corporations turned rather quickly from being profit-challenged to awash in profits and cash. Their value in the stock market now reflects their significant increase in real-life value.

That is not the same thing as saying the economy is healthy. I believe that there has been a tremendous transfer of wealth from individuals—taxpayers and workers—to corporations. Corporations are healthy. But with a 9%+ unemployment rate and housing prices still dropping, the general economy is not healthy, despite the official end of the recession.

Currently, the market is about fairly valued. If it stays that way, then whether the market continues to go up largely depends on growth in corporate profits.

As seen in the table above, S&P expects profits to rise about 14% in 2011 and just 1% in 2012. (The latter number results from a projected drop in profits in Q4 2011, so their estimates grow in 2012 from about the same starting point as 2011. This scenario does not seem realistic to me, and I expect S&P will revise these numbers upward as the year progresses.) S&P expects the P/E ratio to hold steady at around 15. Doing the math, S&P’s earnings and P/E estimates would place the S&P 500 at 1320 at the end of 2011 and at 1321 at the end of 2012. As of last Friday, it stood at 1329.

In addition to estimates from S&P, we know that interest rates will rise, but we don’t know when. Rising rates usually are bad for stocks. It is likely that governmental assistance to the economy will diminish—the tax cuts were extended for just two years, TARP is winding down, QE will probably stop, and so on. Commodity price inflation is already hurting corporate margins. If money stops flowing from the government toward corporations, their profit growth will slow. It is possible—some would say likely—that the employment situation will gradually improve, although we don’t know how fast. That may be good for stocks (more money for consumers to spend) or bad (higher costs for corporations).

We don’t know what valuation the market will place on corporate earnings. If it flatlines, as projected by S&P, growth in market values will simply match growth in corporate earnings.

Nobody can predict the future, and I do not attempt to do so here. This looks to me like a market that is running out of juice, although perhaps not out of momentum. I will manage my capital gains portfolios accordingly: On guard to prevent losses. But I do that anyway. My dividend-growth portfolios will remain 100% invested, as I don’t see anything to suggest that dividend growth will collapse. I review such stocks periodically to reassure myself that the dividend streams are safe and likely to continue growing.

Disclosure: I am long SPY.