Why is the Market So High?

There’s a lot of anxiety about the US stock market. The Dow Jones Industrial Average and the S&P 500 Index are both at all-time highs. In every meeting for the past two weeks, clients have asked these questions. Why is the market so high? Doesn’t that mean we’re due for a pullback? How much higher can it go?

If recent history is any guide, it’s no wonder people are suspicious of new highs. The last two times the S&P 500 Index hit all-time highs, (1,527 in March 2000 and 1,565 in October 2007) they were followed by -49% and -57% bear markets. As of this writing on November 26, 2013, the S&P 500 is above 1,800.  Our tendency to extrapolate future market movement from recent history is called anchoring. Anchoring means that we believe the market will drop dramatically from all-time highs simply because it has done so in the recent past. We are anchoring to these recent experiences and assigning predictive power to them. In reality, this belief is based on irrelevant figures and statistics. Past market movement is no indication of future market movement.  Logically we know this is true, but the behavioral characteristic of anchoring is a powerful force.

But why is the market so high? Quite simply, stocks are priced based on the earnings of companies, and earnings are also at an all-time high. Third quarter 2013 earnings per share on the S&P 500 Index were $26.36 compared to the previous high of $24.06 in October 2007. Logic indicates that stock market indexes should, therefore, also be at an all-time high. The financial media, however, is full of stories that the stock market is over valued. The most popular valuation metric, Price to Earnings or forward P/E ratio was 14.3 in September, after the last full quarter of earnings reports. The long-term historical forward P/E ratio is 14.9, so the market is slightly below average valuation.[1]  On the other hand, Nobel Prize winner Robert Shiller’s cyclically adjusted P/E ratio, at 25.06 in November, is 50% above its long-term historical average of 16.5.[2] Shiller recently told the Wall Street Journal he thinks this number is a concern, but that stocks are not in bubble conditions until the Shiller P/E reaches 28.8.[3] There will always be differences of opinion on the stock market’s valuation.

How much higher can it go? We don’t know, and there is no way to predict the timing of a pullback or correction. The Federal Reserve is considering slowing the flow of easy money called Quantitative Easing in early 2014. Labor markets, although disappointing, are showing signs of tightening. US household net worth is the highest ever, $74.8 Trillion at the end of the second quarter. Nonfinancial US corporations have more than $1.8 Trillion in cash on their balance sheets. [4]

The most prudent strategy is to invest in a well-diversified portfolio of stocks and bonds and to rebalance the portfolio periodically.  Although it’s easier said than done, remember to focus on long-term investing rather than short-term or intermediate market trends.  As long-term investors, remembering the times the market fell 49% and 57% might be fresh and painful, but recognizing that the market continued upward after these declines is the real focus.

[1] JPMorgan 4th Quarter 2013 Guide to the Markets, pages 8 and 10.

[2] Robert Shiller, Yale University, http://aida.wss.yale.edu/~shiller/data.htm, November 27, 2013.

[3] Wall Street Journal, “Nobelist’s Valuation Measure Draws Questions,” Alexandra Scaggs, November 21, 2013; http://online.wsj.com/news/articles/SB10001424052702304791704579210273629381340

[4] Federal Reserve Statistical Release, Financial Accounts of the United States Second Quarter 2013, September 25, 2013.