So, you might have seen the headline last week: “Markets
Soar to New Highs.” Or, “Job Gains Calm Slump Worries.”
The Dow Jones Industrial Average, the index that tracks the
30 largest companies in the US, hit an all-time high, above 15,000, on Friday,
as did the S&P 500, which flew to over 1,600 points. (Think of “points” as
the price per share of this exact index, which is very different from that of a
fund or ETF that reflects the index.)
Ordinarily, this would be time for great rejoicing. If you
have an index fund, it is likely performing extraordinarily well and you have
no complaints at all. Companies’ earnings reports have been generally positive,
although many companies are missing analysts’ estimates.
So what’s the big deal?
A) The big deal is the big picture: although
unemployment has been falling, it is still 7.6%, which is higher than the
targeted 6.5% and much higher than the historical average of 5.8% (the
historical average is only this high because it is taking the past five years
into account, when the rate reached over 10%).
U.S. Treasury yields are still at near-historical lows, with
the 30-year bond – traditionally the highest yielding – at 2.98%. Some blame quantitative easing for keeping these yields so low.
Quantitative easing involves the Federal Reserve buying U.S. Treasuries, with
the purpose of keeping yields low so it is cheaper for companies (and
individuals) to borrow money to buy houses, cars, etc. The central bank began
QE in 2009 and has said that it would stop when the unemployment rate reached 6.5%.
As a result, investors who would typically rely on
Treasuries for yield have not been able to make the money they sought to with
yields as low as they are. So, they began buying stocks. And more stocks. And
more stocks. And even more stocks, pushing the price up to 15,000 and 1,600 for
the DJIA and S&P, respectively.
Some investors are now nervous because they think the market
is overbought and overvalued. Well, the S&P 500’s historical price-earnings ratio is about 15. Right now, it’s nearly 19. So, yes, the market may be a
little overvalued.
B)
Another explanation for the recent surge is that
investors are anticipating stronger growth in the U.S. economy quite soon. One
way that stock prices are determined is by calculating the present value of a company’s future earnings. One could say that the U.S. economy’s future
earnings look so great right now that the high market price is deserved.
Optimism!
I’m inclined to go with option A, based on my education.
Although I am very optimistic about the outlook of the U.S. economy, I think
sending the market to new highs on an uncertain foundation is not sound. I
would advise my friends to hold off on stock purchases until the market cools
down. However, I’m no Miss Cleo and I could be wrong (actually, that would make me a Miss Cleo, haha!).
