The Dow Jones Industrial Average (DJIA) hit an all-time high on Tuesday and continued moving higher. It used to be that the DJIA would quite regularly hit new highs with little fanfare. Rising stock prices were the norm, not the exception—until the massive sell-off began in October 2007.
If you adjust the previous record for inflation, the DJIA would have to clear 15,300 to hit a real all-time high and the S&P 500 Index would have to clear 1,728. (Technically, in inflation-adjusted terms, the peak was in 2000 at close to 2,000 on the S&P 500 Index.) The major indexes, whether it’s the DJIA or the S&P 500 Index, are quoted as price indexes, not total return indexes, which include dividends. Total return versions of those indexes broke records in August 2012. Where was the celebration then?
Small-cap stocks set record highs in late December 2012, and mid-cap stocks have been setting new records since the summer of 2012. To me, a nominal record high is just another number.
Most investors are probably concerned about whether the indexes deserve to be at these levels. With unemployment still high, budget deficits obnoxiously high, interest rates ridiculously low due to Fed intervention, problems in Europe, conflicts around the globe, and oil prices high, why on earth should stock prices be where they are?
In nominal terms, corporate profits have never been higher—they’re more than 7% higher than the previous peak. Even if you adjust corporate profits for inflation, they are just a hair’s breadth away from new records of less than half a percent. Based on trailing earnings, the S&P 500 Index is trading at approximately 14.41 times earnings, while in October 2007, it was approximately 16.27 times trailing earnings.
Investors don’t buy past earnings; they buy future cash flows. And that’s where disagreement abounds about whether the future is bleak or bright. That disagreement is what makes trade take place. If everyone agreed, you’d be hard-pressed to find someone to take the other side of a trade.
The way I look at it is that financial conditions are improving while they were deteriorating after the previous peak. Economic conditions are weak, but it’s pretty easy to identify the major culprits for the current weakness: contraction in Europe, slower growth in China, and fiscal drag in the United States. Companies have proven capable of adapting to the changing environment, maintaining profits, and even expanding top-line revenue. While the future isn’t brilliantly bright, it’s not despairingly dark.
But isn’t the risk of the Fed withdrawing stimulus going to keep a cap on equity prices? Maybe, but it’s not just the Fed that’s propping up equity prices; it’s also the fundamentals of earnings. Of course, I’d argue that the Fedis one of the fundamentals in the market. Interest rates are an important element of any valuation exercise, and the Fed is deliberately working to keep rates low. To say that the market highs are because of the Fed and not the fundamentals is drawing a false distinction between the Fed and the fundamentals. The Fed is like a parent pushing a child who’s learning to ride a bicycle—the parent isn’t about to let go until convinced the child can keep pedaling on her own without falling down. Even if the Fed begins to taper its bond-buying program by mid-year, the Bank of Japan, the Bank of England, and the European Central Bank are likely to step in.
Enjoy the record high, but don’t dwell on it.
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