Happy Anniversary To The All-Time Highs

Includes: AAPL, DIA, EFA, GLD, SPY
by: The Financial Lexicon

Five years ago, on October 11, 2007, the Dow Jones Industrial Average (NYSEARCA:DIA) and the S&P 500 (NYSEARCA:SPY) reached their all-time highs. On that day, the Dow topped out at 14,198.10, and the S&P 500 topped out at 1576.09. The Nasdaq, of course, reached its all-time high in March of 2000, at 5,132.52. That is a level that, more than 12 years later, the Nasdaq is still more than 40% below.

Interestingly enough, prior to 2007, October was the month investors could most rely on to end bear markets, not start them. According to the "Stock Trader's Almanac 2012," bear markets ending in 1946, 1957, 1960, 1962, 1966, 1974, 1987, 1990, 1998, and 2002, all occurred in October. Additionally, the roughly 20% sell-offs that occurred in the major market indices in 2011 also ended in October.

But while October was historically known as the month to end bear markets, it has also been known as the month of nasty surprises. The stock market crashes of 1929, 1987 and 2008, each occurred during October, as did brutal sell-offs in 1978 and 1979, and single-day surprises in 1989 and 1997. Moreover, the bull market ending in 2007 peaked in October.

For one reason or another, October has historically marked inflection points in the major U.S. stock market indices. With the fiscal cliff fast approaching, earnings growth for the S&P 500 at its slowest since the bull market began, and forward earnings estimates on a downward path, it is a good time for investors to be mindful of October's role in stock market history. Maybe all the previously mentioned inflection points and brutal sell-offs occurring in October is merely a coincidence. And with unconventional monetary policy distorting prices in many parts of the financial markets, perhaps it is futile to spend time discussing seasonalities.

But also worth noting is that as much as investors like to think the stock market prices in known unknowns ahead of time, that is not always the case. Five years ago, when major stock market indices were making new all-time highs, the U.S. economy was just weeks away from officially entering a recession. Furthermore, at that time, financial market stresses from the declining housing market had already appeared. But then, much like today with respect to troubles in Europe and slowing worldwide economic growth, hope ruled the day. Hoping that central banks and policy makers can forever protect the financial markets, driving asset prices ever higher is something in which financial market participants are well versed. Yet when hope in the abilities of central banks and politicians to successfully navigate investors through troubled financial waters becomes the primary driver of rising asset prices, which I contend it is today, then shifts in sentiment can happen suddenly and appear irrational.

Incidentally, for those who find October's role in stock market history of interest, you may like to know that the Dow Jones Industrial Average recently made a new bull market high on October 5, before turning lower, and the S&P 500 challenged its bull market high before turning lower. Will this October join others as a major inflection point?

It appears to me that the U.S. economy and the S&P 500 are far too reliant on three things: unconventional monetary policy, corporate cost cutting initiatives, and Apple's (NASDAQ:AAPL) earnings growth. Quantitative easing has been ongoing for more than three-and-a-half years. The goal of quantitative easing is to prop up financial asset prices until a self-sustaining economic recovery takes hold. Yet the diminishing asset price returns from each round of QE appears to indicate that investors are losing patience. In order to continue propping up financial markets, including stocks, the Fed will need to print money in ever greater amounts. Or corporate earnings growth can ramp up and remove from the Fed the responsibility of propping up asset prices. Yet after a few years of impressive cost cutting, corporations are and will continue to become more reliant on revenue growth to boost earnings.

With anemic wage growth in the United States, a slowing economy in China, and very serious structural problems in Europe, at this time, betting on enough revenue growth to drive stock prices significantly higher from here does not seem appropriate from a risk-reward standpoint. One caveat to that would be if Apple were to crush earnings expectations. Given its top weighting in the S&P 500, its near 20% weighting in the Nasdaq 100, and the fact that Apple's earnings growth has masked widespread weakness in the broader growth of S&P 500 earnings, its earnings report later this month will be the one to watch.

If you are an investor with a time horizon measured in years rather than weeks or months, it makes very little sense to put new money to work in broad market indices at this time. Before doing so, I would want to see not only a clean, consensus-crushing earnings report from Apple, but also some indication that the fiscal cliff and the fast-approaching debt ceiling debate will be dealt with in a way that helps markets avoid the same type of brutal sell-off experienced last summer. Traders find short-term opportunities each and every day. But if you are one of the millions of investors with multi-year time horizons, using index funds as a means of gaining exposure to stocks, now is not the time to put your foot on the accelerator.

There is virtually no chance that stocks have priced in the earnings declines that would result from a failure to resolve the fiscal cliff. Likewise decisions made during the upcoming debt ceiling debate could also have serious consequences on future corporate earnings growth. It is also highly unlikely that stocks have priced in any type of negative outcome regarding the European situation. Those are all very real risks in the months ahead.

What stocks have priced in is a Fed willing to do moderate levels of QE on an ongoing basis. Stocks have also priced in the expectation that politicians will not allow the fiscal cliff to occur on a permanent basis. While it is hard to believe that Congress will accomplish anything in December, there is widespread discussion about the fiscal cliff happening on a temporary basis in January. Finally, stocks have also priced in current forward earnings growth projections of 13.41% over the next twelve months.

Unless we get a stellar earnings season including guidance that gives investors reasons to put new money to work, investors are really just buying on the hope for continued money printing. In that case, I would rather buy gold (NYSEARCA:GLD). And when the time does come to once again invest heavily in stocks, it will likely correspond with some sort of resolution out of Europe. In that case, investors will likely make more money buying the more-than-4%-yielding MSCI EAFE Index Fund (NYSEARCA:EFA) than they would buying the S&P 500.

For now, remain on hold, patient, attentive to the upcoming challenges, and mindful of October's role in history. Good luck and happy investing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long gold.