The Dow Jones Industrial Average exceeded its 2007 record peak with great fanfare this week.
For me, record highs are a cause for contemplation and create a good time to re-examine an investment strategy.
The questions I find myself asking are: Are these record highs justified? Can this rally continue? What are the special risks inherent in this market?
When asking if this new record high is justified, primary factors to consider are valuations and economic conditions. From a valuation point of view, according to Thomson Reuters data, The S&P 500 index is trading at 13.6 times estimated 12-month earnings. At the previous market peak in October 2007 this ratio was 14.9. This would suggest stocks are still on average about 9 percent undervalued from similar periods in recent history.
At the same time, nearly all important economic indicators released in the past few months have met or exceeded investor expectations, and the overall size of the U.S. economy is now about 13 percent larger than it was during the 2007 market peak.
So from a fundamental point of view, an argument can be made that stock values at current levels do not appear to be stretched.
When considering whether or not the rally can continue, I believe the two primary factors are the Federal Reserve policy environment and the level of commitment that individual investors have to the stock market.
No one could argue that the Fed’s current policy stance is highly accommodative to higher stock prices. With interest rates near zero, the competition for investor dollars presented by bonds and deposit products is practically nil. Interest rates near zero also create incentive for sophisticated investors such as hedge funds to add additional leverage to their portfolios, using borrowed dollars to invest in stocks.
One proxy used to measure the sentiment of individual investors is flows into open-end mutual funds. According to mutual fund research firm Lipper, about $800 million was injected into U.S. stock mutual funds last week. This marked an eighth straight week of positive stock fund inflows, the longest such stretch since March 2011.
This money appears to be coming out of cash type holdings as bond fund inflows have not really slowed. If individual investor money actually begins flowing out of bonds into stocks, this could in theory provide considerable sustainability to the rally.
So on the opportunity front, things look fairly good. Investors must of course always consider risks as well.
To me the primary risks to this market are inherent in the length of the rally. The market has not experienced a meaningful correction for 19 months. This length of time is not typical and we are probably due for a breather.
And from a broader economic perspective, with and government out of stimulus money and the Fed having already used every tool in the box to support the economy and financial markets already, if we do experience a “black swan” event of some type, there is very little safety net left. This one factor more than any other makes me wary about increasing my exposure to stocks at these levels.
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