Why The Approaching Stock Market's New High Matters A Lot

Includes: DIA
by: John Tobey, CFA

ArrowsRecent articles note that the stock market is nearing its all-time high. So how should we view this news? Is a new all-time high important information, or is it just a media tidbit, similar to the Dow Jones Industrial Average (DJIA) crossing some seemingly important value like 10,000?

Let's talk first about that latter event. While the DJIA passing through 10,000 may be visibly impressive, the number itself results from happenstance. Determinants are the date the index was created (May 26, 1896), the beginning value (40.94), the stocks chosen (originally 12 industrials; now 30 from many sectors), how it's calculated (price-weighted with divisor adjusted for component changes) and the company component changes that occurred along the way (both from corporation actions like stock splits and from company replacements in the index). Alter any of those factors, and the numbers become uninteresting. In other words, crossing 10,000 should be viewed as "meaningless" as passing through 9,386.

Now, let's look at a new high. Here, the number doesn't matter. For example, the DJIA's all-time high is 14,198.10 set on October 11, 2007.

(click image to enlarge)

DJIA price chart

(Chart courtesy of StockCharts.com)

While the number is uninteresting to look at, the market's crossing that level will carry valuable information, especially in today's market. When the stock market exceeds its previous all-time high level, we gain insight into both business fundamentals and analysts'/investors' outlook for stocks. Because all-time highs necessarily mean fundamentals and/or outlook are better than ever, they serve as proof of business growth and/or stock enthusiasm.

In today's market, an index all-time high is especially meaningful.

In pre-2008 stock market periods, an index move to new high ground was viewed as proof that the economy was sound and growing. Plus, it showed that analysts and investors were bullish about future prospects.

In today's stock market, a new high will carry two additional meanings:

First, the lingering worries (especially the "mega-fears" like global economic recession) will look wrong-headed. Businesses and stocks will have moved fully beyond the Great Recession and financial breakdown effects. Breaking through that five year old high will mean that corporations and their shareholders have not only weathered the storm, but are now above the pre-problem top.

For investors a new high underlines the fact that none of the mega-fear visions came true. There was no housing implosion, no deflation (or runaway inflation), no financial collapse, no 10% and rising unemployment, and no U.S./global double-dip recession/depression. Moreover, long-term cultural shifts failed to materialize, with the U.S. consumer now back to spending, borrowing and gaining a positive outlook. ("Boomerang" home buying by previously foreclosed homeowners is a great example of how simplistic mega-fears can be so wrong.)

Second, investor concerns about stock risk will look overly conservative. New highs will bring "return" back into investment thinking, moderating the past focus on risk avoidance.

Here's a way to understand how a new all-time high can shake up thinking. Imagine a 2012 all-time stock high being forecast in the past three years, especially when the mid-year, mega-fear sell-offs were in full swing. Such a forecast would have been derided, so large and fresh were the Great Recession's effects and the financial system's travails. Therefore, the fact of the all-time high occurring could create what logic could not in those previous years: A less fearful vision of owning stocks as a long-term investment.

An added bonus: Fundamentals outweigh optimism

The market has been lifted more by fundamentals than by investor enthusiasm. Today's attractive stock valuations illustrate this fact.

How did fundamentals drive the market up so much? Many companies, even at the recession's depths, were in sound financial shape. Therefore, managements were able to adopt strategies that could produce earnings growth from reduced levels. The typical sharp sales rebound from the recession's trough, coupled with economic growth, produced a good earnings growth rate. Operational and financial leverage boosted the earnings growth even further.

If the market makes a new high, what's next?

First, expect fundamentals to continue improving. The economy, while growing slower than people wish, is nevertheless improving. That growth, whatever the level, provides the foundation on which corporate earnings can continue rising. While much of the rebound jumps have occurred, companies are still able to produce earnings growth faster than sales growth.

Second, expect investors to begin increasing their allocation to stocks. With valuations attractive and the positive messages provided by the stock market's new high, the "return/risk" view of stocks could become more balanced. There is room for valuations to increase, so stock returns could outperform company earnings growth.

The bottom line

If/when the stock market makes a new high, good things likely will happen. In today's stock market, the event will more than confirm positive growth and outlook. It will also signal that, for corporations and the stock market at least, the troubled times have been conquered and the previous good times have been surpassed. (And remember that those 2007 good times were partially built on unhealthy real estate and financial activities.)

Additionally, this new high will be "real," based on fundamentals, not stock popularity. Therefore, a new all-time high could mark the end of the past three years' overblown, mega-fear cycles. With a more balanced view of stocks as a long-term investment, investors will likely begin increasing their stock allocations.

Therefore, there is the possibility that the stock market's reaching new high territory could foster a more optimistic bull market, with fundamental growth continuing and investor interest in stocks expanding.

Disclosure: 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: Positions held: U.S. stocks