26 Jan 2018 Are Stocks Too High?

The stock market continues to party higher and higher with no signs of stopping, or for that matter, any real weakness. As it rises, some consider increasing their exposure to stocks, particularly some big names Amazon, Apple, Alphabet (Google) Facebook, while others consider decreasing their risk feeling the market is overdue for a tumble. Our regular readers know we don’t make market forecasts, however, some historical perspective and wisdom might be welcome at this point, as the Dow Jones Industrials march steadily toward another 1,000 point milestone of 27,000.

• First, let’s note that a 1,000 point increase doesn’t mean what it used to. Way back when I started in this business, the Dow was hovering around 1,000. Back then, we had to wait a while (5 years, during the most powerful bull market in history) for a 1,000 point move. And that move represented a double, or a 100% increase in the index. That’s big. Today, a 1,000 point increase from 26,000 to 27,000 is 3.85%, mere chump-change lately.
• The market’s strength is on firm-footing when we consider the economics behind it. The economy appears poised to break out of its decade-long anemic growth of 2%, to achieve growth levels of 3% or more. The difference between 2% and 3% growth for the world’s largest economy is not simply 1%, as simple math suggests, it is 50% in economic terms. In increase in GDP from 2% to 3% in today’s economy of 19.7 trillion would generate almost $2 trillion more money in a year. That increase represents millions instead of hundreds of thousands more people working and spending, driving corporate earnings higher, and as a result, stock prices.
• Tax cuts are huge for companies and their shareholders. As we have seen lately, when companies keep more of their profits, they increase their dividends to shareholders, pay bonuses to employees, and announce large plant and equipment purchases. These investments in their production capacity are driven by their managements’ improved confidence in the future growth and health of the economy.
• Tax cuts, larger dividends, increasing wages and job opportunities, and bonuses are significant contributors to consumer spending. When these are rising, individuals’ confidence in the economy grows, they spend more, corporations make more profits and stocks rise. Consumption represents more than 70% of our economy.
• The President and the Congress are in the early discussions to rebuild and repair the nation’s infrastructure known as the Four R’s – Road, Railways, Runways, and Rivers. The billions invested in these resources create millions of jobs and improve the country’s efficiency in transporting raw materials to plants and finished goods to consumers throughout the country.
• What about valuations of stocks? The long-run average of the Standard & Poor’s 500 Price to Earnings (P/E) ratio is about 16.5. The ratio represents the price of a share of stock divided by the last 12 months’ earnings for that share. The ratio currently stands at 26.6, putting today’s level 61% higher than the average. But take a look at the chart below to gain some perspective and see that the current level is just a bit higher than former peaks and nowhere close to the level reached during the the Internet/Tech boom of the 1990’s. The spike in 2007-2008 is due to the significant, but short destruction of confidence and earnings of the Financial Crisis and Great Recession.

• Interest rates, while up a bit, remain historically low. When interest rates and bond yields are low, people gravitate to stocks for better yields. We have seen that for much of the past decade. The ‘Fed Model’ as it is known, suggests that when for example, the 10-year Treasury bond yield is 2.5%, investors would, theoretically, be willing to pay a price for stocks that also yields 2.5%, suggesting a P/E for stocks of roughly 40 or (1/.025). Indeed the 10-year Treasury yield and the S&P 500 earnings yields usually follow each other rather closely.
• Finally, the mid- and long-term inflation outlook, as indicated by intermediate and long-term bond prices, remains benign. Bond buyers don’t believe that economic growth or wage price pressures will rise to the level of causing inflation. Another way to state it is that bond buyers, who look out much farther than stock buyers, don’t see the economy growing at levels that would cause overheating and inflation.

We do not know when stocks will enter what is known as a correction phase – a time when stock prices ‘correct’ or fall to reflect lower economic and earnings expectations than existed days or moments before. But given that more money will soon be in the hands of businesses and consumers, interest rates likely remaining relatively low, and that stock valuations have considerably more to go relative to our last super-cycle that was the Internet/tech boom of the 90’s, if you are invested appropriately according to need and risk, there is nothing to worry about.

If, on the other hand you are not sure that you are appropriately invested according to your near- and long-term goals or if you worry that you may be taking more risk than you can stomach during a rough market, give us a call. We’d love to help.