Happy Anniversary, Bull Market

March 19, 2014

After a largely uninterrupted five-year run-up in stocks that began in early 2009, optimism is high, but so are doubts over the sustainability of good times for stocks.

At 150% and counting, the Dow's run is one of the best ever in such a short period, and the 5th best bull market in over a century. But the big move comes off of a major hit to the market. The Dow’s mere 15% gain from its previous peak in 2007 isn’t nearly as impressive. The Dow is only up 40% (not including dividends) from the early 2000 peak. That's one reason stocks aren’t as overpriced or “due” for a major correction as this big of a run would normally imply.

In general, this new peak is an all-around better deal than the last two, although it's still getting stretched valuation-wise, which will lead to lower future returns. This could mean just more subdued single-digit yearly returns, or an actual slide followed by higher annual returns. 

There's no perfect way to predict future returns. No one knows how the economy and earnings will do far into the future, or where taxes will be if a hot economy collapses, or even if one country decides to invade another. 

While valuations are important to future returns, they're only as valuable as future earnings. Paying a low price for stocks before slow earnings growth is not necessarily better than paying a high price before strong growth. Right now, stocks are historically on the above-average valuation scale. But if earnings grow fast, we could have good deals in the market in a few years if prices plateau. If earnings sink in a sooner-rather-than-later global recession, current valuations will look very expensive. 

Your odds of better future returns will increase the more the market falls, not the more it rises. Big moves up generally require strong future growth to catch up to prices. Big slides, like in 2007-2009, simply require a return to normal. 

While using market price-to-earnings levels or P/E ratios, particularly ones averaged over a few years, can help determine market over-pricey-ness, they won’t predict the future. Actually, valuation levels from most of the last 100 years shouldn’t really be considered when evaluating today’s market: there's just too much money investing in stocks today, and too many investment vehicles to allow stocks to fall to historically low valuations when individual interest in stocks was lower (and, often, interest rates were higher - which should have made stocks less valuable). As the world gets richer adjusting for inflation, assets are going to get more expensive.

This is not some "This time, it’s different" logic like you might see at the top of a bull market rationalizing ever-higher valuations. If  stocks get as cheap again as they were at the bottom of the last two bear markets, investors should get optimistic, because the probability of even lower valuations is slim, just because a half-century earlier, we saw lower prices near the bottom in bear markets. You're not going to get the deal of the century. You might get the deal of the decade.

For us, overall investor enthusiasm is a better indicator of when the good times are going to peter out, if not flat out end, than market valuations (although valuations tend to be high during periods of high investor enthusiasm).

For much of this bull market, investors favored bond funds and generally ditched stock funds, particularly funds investing in U.S. stocks. 

This all turned around in 2013, which one research firm noted was the biggest year of inflows to stock funds in 21 years, at least in dollars (if not percentage of assets in funds). Bond fund inflows suddenly turned into major outflows in the summer of 2013. We started running the highest bond and lowest net stock allocations of the 5-year bull market in our Aggressive portfolio during 2013, part of our strategy of doing what fund investors are not doing.

Since these inflows are not as high a percentage of total assets in funds as the real stock-crazy years of the late 1990s, and much of the past decade has seen lackluster equity interest, it’s a bit early to call the end of days for stocks, but it probably does mean the best days of this run are behind us.

In addition to huge inflows, there are other indicators of investor enthusiasm – which can capture real estate investors and even how lenders behave.

Back in 2006, there was hardly anything that wasn’t worth lending money for. This, of course, led to trillions of losses on bad loans – far more than was lost in ill-conceived dot com investments from the late 1990s. 

More recently, it appears companies with good growth potential have no shortage of investor cash, from startups to publicly-traded growth stocks. Today, companies with the best growth opportunities trade at prices that will make high returns from here unlikely.

I recently came across research showing the economy is negatively correlated with positive press articles and even presidential addresses – reporters become optimistic near the top.

One indicator I discussed here back in 2009 was the correlation of record tall skyscraper construction and bull market peaks. As it turns out, it works better than P/E ratios, at least according to a recent 40 page paper titled Tower Building and Stock Market Returns in the Journal of Financial Research, which adds some intellectual heft to my big and tall building observation.

Today, we’re seeing some warning signs of overenthusiasm in real estate, mostly old dead projects that have come back to life again. The press is hardly giddy about the economy, though stock market coverage is getting a little optimistic. Mutual fund inflows are too large, but not at 1999 levels. In general, these non-valuation , valuation gauges are on the high side, just not quite bubble-about-to-burst level.

We  continue to watch for signs of overconfidence by investors. Now's a better time to be holding steady or cutting back on stocks than adding. We’re in a safer place than in 2000 or 2007, but future returns will be muted. Bonds bought on weakness likely won’t drag on portfolio returns as much as expected by those selling bonds for stocks today.