Still, it's certainly not bad news that we finally recovered back to the 2007 market high. In fact, it didn't take all that long, historically speaking. Ned Davis calculated that it took 5.4 years for the market to make its roundtrip after its 54% 2007-2009 decline. In the two previous crashes (declines of 40% or more), it took 9.8 years to bounce back after the 1974 bear market, and 25 years to recover after an 88% plunge during the Great Depression.
Setting a new high doesn’t make the market attractive, nor expensive. Granted, I’d rather have the market move up than down, but the fact that it is now at a “new high” doesn’t necessarily make it expensive, nor does it indicate anything about the market’s future prospects. Think about it. Bank savings accounts make “new highs” every day. Their principal doesn’t go down, and each day they earn a tiny fraction of a percentage in interest, which is added to yesterday’s total, so that each day the savings account makes a new personal best. But this steady progression upward doesn’t make it an attractive investment because the alternatives to savings accounts are (generally) doing so much better. What makes a savings account attractive, or not, is its rate of return (i.e. its income-generating power).
With stocks, what makes a market attractive is its income-generating power and its valuation related to its future earnings potential. In the case of stocks, the Dow Jones Industrial Average currently trades at only 13.5-times earnings. For most of the past 20 years, this group of stocks has traded at more than 15.5-times earnings. Based on current projected earnings, if the Dow just gets back to that average multiple of 15.5X and current earnings forecasts are met, the index could rise to nearly 18,000 in the next few years. That cheap current valuation, and potential for additional upside, is what makes equities exciting, not the fact that we’re at a new high.
Folks worried that the current market is expensive, because the last time it reached this level it peaked, ignore the fact that earnings power is much stronger now than was the case in 2007, the last time we were at these levels. Inflation-adjusted earnings are just getting back to 2007 levels, but in 2007 the earnings were jacked up by a number of builders and financial companies that has faked their earnings amidst the real estate bubble. Today, it is harder to find similar instances of earnings puffery, although some companies are clearly beneficiaries of today’s unrealistically low interest rate environment. In general, however, earnings quality is much better today than was the case back in 2007.
Still, we will caution investors not to get too excited about the stock market. Particularly when the government is holding down interest rates, punishing savers in an unsustainable attempt to juice the financial markets, some might be tempted to invest “savings” in the stock market. We’ve always said that it’s a mistake to confuse “green money” (savings, which typically can’t tolerate the ups and downs of the stock market) with “red money.” We’ve had our red money mostly invested in the market since 2009. Investors who succumb to the temptation to move “green money” into the market are taking a big risk that interest rates go back up and the next time the market falls, they will succumb to the temptation to take it out of the market at just the wrong point in time.
We’ve often said that we prefer it when pop culture “news” dominates the front page instead of business or economic events. We would much prefer Britney Spears in the headlines than things like “sequestration” or “tax increases” or “unemployment.” Having said that, if the media is going to focus on an economic story, probably the best event they could focus on would be the market reaching new highs.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .
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