Download U.S. Stock Markets Nearing All Time Highs: Why They Can Move

U.S. Stock Markets Nearing All Time Highs:
Why They Can Move Higher
April 2013
For literally years, actually four years now, investors in stocks, market participants, media
pundits, and so-called experts have been focused on all that is wrong in the world. Too much
debt, check. A potential Eurozone break-up, check. Lackluster job growth, check. The end of
the economic world as we know it, check. However, despite all the doom and gloom and
predictions that missed the mark (widely), U.S. stock markets are within a stone’s throw of
reaching their all-time highs.
As you can see in the chart below, the Dow Jones Industrial Average is at a level not seen since
late 2007. Surprisingly, the discussion still remains centered around what can go wrong. We
often say that when only one side of the story is told, one argument easy to make, it’s time to
look at the other side, which is precisely the objective of this commentary.
10 Year Chart of Dow Jones Industrial Average
What Can Drive Markets Higher?
We are not going to bore you by revisiting the downside case, except to mention that equity
markets are not going higher because Cypriots can access their cash at ATMs. Global equity
markets can still move higher because of three major factors:
1. Fundamentals
2. Absence of Crisis
3. Human Behavior
Fundamentals
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U.S. stocks are trading at 15 times trailing earnings, 2.25 times book value, both below
historical averages.
At prior peaks in 2000 and 2007, stocks traded at 5 times and 3 times book value,
respectively.
Outside the U.S., both developed Europe and emerging market stocks trade at a discount
to U.S. markets.
The S&P 500 earnings yield spread is at a 30-year high relative to investment grade
bonds. Earnings yield is the inverse of the price-earnings ratio and is used to compare
stocks to other yield equivalents, such as bonds (for example, P/E=15; earnings
yield=1/15 or 6.66%).
S&P company profit margins continue to remain near all-time highs. People have been
waiting for margins to revert to the historical mean, only to be disappointed. High
margins are a function of high productivity and low wages. The silver lining should
margins fall? Wages would likely grow, which would be great for the consumer,
demand, and investment.
Housing in the U.S. continues to be robust, manufacturing improvement is in the works,
and the ability to unlock vast reserves of oil and gas are long-term secular drivers of
business and investment.
Absence of Crisis
Believe it or not, it has been almost five years since the global financial crisis. Since late 2008,
when banks and credit markets were truly on the brink, there has been no lasting negative event
that impacted stock and bond investors. For sure, there has been lots of noise and plenty to
worry about, including
1.
2.
3.
4.
5.
Greece, Portugal, Ireland, Spain, and most recently Cyprus
U.S. political dysfunction
Downgrade of U.S. government debt
Fiscal cliff
Unchartered central bank intervention
But let’s look at what actually happened. The European Central Bank backstopped its banking
system. We are aware that European troubles still persist and that a real solution is not in place;
however, we think those betting on an imminent Euro collapse are severely underestimating the
power of monetary intervention and committed central banks.
Turning to the U.S., the downgrade of government debt caused a one-month sell off in stocks
that quickly rebounded. I mean, did people really think that AAA to AA meant the U.S. won’t
pay interest on its debt? A year later the dreaded fiscal cliff caught everyone’s attention–even
Pathlight produced a webinar on the topic. The fiscal cliff had as much bite as an 80-year old in
a nursing home and reminded us of the overhyped Y2K, if anyone remembers that.
Pathlight’s Investment Team is not naïve enough to think that all the problems are behind us and
that we are in a green light investment cycle. What we believe is that the things that almost sank
the financial system are much improved. The banks are in way better shape. Bad debt has been
written off/down, and real estate is vastly improved. Confidence in counterparties, which is the
essence of credit markets, has returned. If you don’t believe us, look at the two-year chart of
gold, which is often used as an insurance policy against catastrophic events. As seen in the chart
below, the price of gold as measured by the SPDR Gold Trust ETF (symbol GLD) has been in a
downward trend since mid-2011, falling more than 20%. Those who sold stocks and loaded up
on gold and cash following the debt downgrade have been sorely disappointed, while waiting for
the next crisis. Worried about Europe? There are plenty of reasons to be. However, we urge you
not to underestimate the power of Europe’s commitment to keep the Euro and EU intact.
Two Year Chart of the SPDR Gold Trust
Source: Thompson Reuters; April 2011-April 2013
Is there another crisis on the horizon? History would suggest so. However, in the current
environment of improving fundamentals, re-accelerating industries, and committed central
banks, the next one is not imminent. For those expecting in the near term that interest rates will
skyrocket, inflation will become astronomical, and/or the dollar will plummet, you may be sorely
disappointed.
Human Behavior
Like it or not, Central Bank monetary policy has been instrumental in encouraging investors to
buy stocks and real estate. The rebound in these two investment classes has helped the wealth
effect and each respective market. Clearly, the benefit is most captured by the upper income
individuals and has not yet trickled down and helped accelerate job growth. It has, however,
increased confidence for investors, which alone can be a powerful driver of continued higher
prices for both stocks and real estate. We are far from bubble territory, however. Despite what
you may hear, money is not pouring into stocks like it was in the late ‘90s tech bubble. In fact,
money is trickling in, with a significant portion still moving into bonds (for some reason). We
believe with improving fundamentals and the continued absence of crisis, that human beings will
respond as they usually do and gradually become more greedy as they become more confident.
We’ll leave you with a table that shows past major events and corresponding stock market
performance for the “year” in which the event took place. The table is meant to highlight the
resiliency of people, markets, and our system. It’s also to remind you that there have been
numerous social, economic, and global events that have shaken the world; however, they do not
always translate into a negative equity market. In fact, quite often, the opposite is true.
Event
Great Depression
Pearl Harbor
Kennedy Assassination
OPEC/Inflation
Black Monday
S&L Crisis
1st Gulf War
Peso Devaluation
Asian Financial Crisis
Russian Default
Dot-Com
Credit Crisis
Year
‘30,'31, '37
1941
1963
1974
1987
1989
1991
1994
1997
1998
2002
2008
S&P 500 Calendar Year
Return
-34.42%*
-11.59%
22.80%
-26.47%
5.25%
31.69%
30.47%
1.32%
33.36%
28.58%
-22.10%
-36.94%
Return data sourced from Standard & Poors. * Great Depression data is average annual return
Still Doing Our Job
Make no mistake, the Investment Team at Pathlight is not abandoning our rigorous analysis and
focus on risk management—that will never change. In fact, there is still plenty to worry about.
However, in our opinion, this widely telegraph correction or market sell-off that many are
waiting for is not preordained, no matter who is predicting it. In an improving environment that
people don’t seem to fully appreciate, we believe it is important to recognize that there are
several factors that could drive equity markets higher.
This newsletter is limited to the dissemination of general information pertaining to Pathlight Investors, LLC’s
(“Pathlight Investors”) investment advisory services and general economic market conditions. The information
contained herein should not be construed as personalized investment advice and should not be considered as a
solicitation to buy or sell any security or engage in a particular investment strategy.
Past performance is no guarantee of future results, and there is no guarantee that the views and opinions expressed
in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable
for all investors. Pathlight Investors is an SEC-registered investment adviser with its principal place of business in
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requirements imposed upon registered investment advisers by those states in which Pathlight Investors maintains
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A list of all recommendations made by Pathlight Investors within the immediately preceding one year is available
upon request. Not all clients own the holdings listed in the charts above. Clients may own different securities based
upon their individual needs and investment strategies