Despite the fierce political environment in Washington, Wall Street (and Main Street) have had a solid 2017 so far. In recent weeks, all three major stock indexes have scored record closes. Although we’re in the midst of a bull market, some investors are leery. The question on their minds: Does the market at all-time highs signal danger? Why the hand-wringing? We are, after all, still living in the wake of the market devastation wrought during 2000-2002 and 2007-2009. From March 2000 to October 2002, the S&P dropped almost 50 percent, and the Nasdaq dropped almost 80 percent. Ouch. In the 2007-2009 financial crisis, the S&P 500 at one point had lost over 55 percent. Ouch again.
But these “bubbles of the past” aren’t necessarily a glide path for today’s market highs. Today’s healthy market doesn’t always spell tomorrow’s devastating tumble. When markets rise, often investors will act out of exuberance, trying to hop the equities train to unreasonable returns. Think tech stocks in 2001 and real estate in 2006. In these climates, a bubble inevitably forms, then bursts. But that’s not what we’re seeing today. Investors aren’t piling into stocks like it’s 1999. Instead, stock investors have remained measured and cautious over the past several years.
Much of this caution stems from the aforementioned crisis periods, which have imprinted a permanent wall of worry in investors’ psyches. This residual market hangover affects how people invest today. Think of the mindset the Great Depression created in our grandparents. They knew what it was like to live with virtually nothing, so they adopted a mindset of frugality, often for the rest of their lives. People today have an analogous mentality — invest with care.
As the market goes up, it is only natural that people are skeptical. What’s important to remember, though, is that the stock market is simply an odometer reading of how companies are progressing in any given economic environment. In this case, however, instead of miles, the odometer measures a group of companies and their ability to continue to earn profits.
In addition to earnings, investors also expect to pay a certain price or “market multiple” for profits. So the market’s odometer reading, or overall level, is a function of two important ingredients. First, aggregate earnings — a profit number for companies as a whole. Second, the multiple that people are willing to pay for the rights to future profits. This second ingredient also refers to how “cheap” or “expensive” the market is. Historically, paying 10 times profits is considered inexpensive, while paying 30 times profits is considered expensive.
Let’s look at earnings for 2017. For illustration, the S&P 500 is expected to earn about $135 this year. This $135 figure can be multiplied by the number of times people are willing to pay for those earnings (the “multiple”). Today, this multiple is about 18. Multiply 135 by 18, and you have 2430. This past week, the S&P 500 hit 2,440. So numerically, markets are technically at a reasonable level. And a multiple of 18 is considered well within the “safe zone” (i.e., not overly expensive). For instance, in 1999, the multiple skyrocketed to 36 — that’s bubble territory.
Still, people are often surprised and unsettled by all-time highs. But let’s consider this point in a different light. Imagine a hypothetical where we are operating in a vacuum, and the price to earnings ratio (P/E) remained static. Under this scenario, while the economy and earnings are both growing every day, little by little, eventually we would reach an all-time high. This outcome isn’t a surprise so long as earnings are growing. Instead, it’s the expected outcome. So where we are now is expected. Even though it may feel surprising, it isn’t.
If we were able to forecast what earnings would be over the next year, we’d still only be halfway to forecasting where markets will be. Even though we may have a good read on what companies will earn over the next year, it’s absolutely impossible for anyone to know where the multiple will fall. Even if the multiple makes only a small shift, say from 18 to 16, the result on the market is significant. This slight multiple drop would produce a substantial 11 percent drop in the market’s level.
But, unlike our hypothetical, the real world doesn’t operate in a vacuum. Earnings expectations are certainly not always up. And variables like investors’ emotions move the market’s multiple around.
So where does that leave us? From all appearances, it leaves us living in a thriving bull market that’s unloved by investors, right now. How the market moves depends on myriad factors, like investor confidence, interest rates, inflation and (back to the bubble) people’s exuberance or pessimism. Like so much in life, boil it down and our emotions are huge drivers. Not only do they influence how we invest our money, acting together investors’ emotions affect how the market fares.
The takeaway is that, today, the market isn’t standing on a precipice waiting to fall. Crashes don’t simply happen because the market gets too high. Crashes happen if the future of earnings turns bleak. There’s no hint of that on the immediate horizon. Crashes also happen when investors get too exuberant. But the data shows us that we’re not there yet; domestic equity mutual funds have seen net outflows of $150 billion in the past 8 1/2 years.
Put another way, as stocks have climbed a wall of political and economic worry over the past 8 1/2 years, investors have remained skeptical of stocks — exactly the opposite of irrational stock exuberance or chasing stock returns. Instead, about $1.6 trillion has made its way into bond funds, showing investors still have a high appetite for stability and modest returns versus higher potential returns accompanied by higher volatility that comes with stocks.
With today’s 24/7 news cycle, it’s natural to stay in a permanent state of worry. So the next time you hear the words “all-time high,” remember the earnings odometer, which is more than just a number.
Read the original AJC article here.
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