With Stock Prices Soaring, Investors Fear Another Crash
Dow 14000? Again?
Like Lucy with her football, forever enticing Charlie Brown to one more kick, Wall Street is waving at Main Street yet again and shouting, "Have a little faith—try me one more time."
The Dow Jones Industrial Average this month briefly crossed 14000, for the first time since the boom of 2007.
For the broader Standard & Poor's 500-stock index, the recent surge is even more historic. The S&P, which touched an ominous intraday low of 666 during the crash six years ago, has surpassed 1500. The first time it broke that barrier was April 2000—the peak of the dot-com era bubble.
Since then, the market has collapsed twice and recovered twice. Each time, the S&P 500 has made it just over the 1500 line before plummeting. Will this time be any better?
There are many on Wall Street who will tell you that yes, the third time's the charm. The economy is recovering, they say. Unemployment is falling, albeit slowly. Inflation is tame. Corporate America—which is what you buy when you buy stocks—has never been in better shape. Companies are loaded with cash and their earnings are strong.
And stock prices at current levels look remarkably cheap on the most common metrics, they add. For example, the S&P 500 trades at just 13 times forecast per-share earnings for the next 12 months, which is slightly below historical averages.
If that doesn't convince you, they will add that stocks look especially cheap when compared with the alternatives. The interest rates on bonds are at historic lows. Ten-year Treasury bonds yield less than 2%, which is less than inflation. Cash pays a little over nothing at all.
Main Street is warming to the idea. The Investment Company Institute, which represents the mutual-fund industry, reports that in the past few weeks the ordinary investor has started to return to the stock market. Mutual funds that invest in U.S. stocks are reporting net inflows, after years in which investors cashed out.
But whether Main Street is buying Wall Street's arguments is another matter. It is more likely that the average investor just can't resist the sight of a rising market, any more than Charlie Brown could resist the sight of Lucy holding a football.
ICI data show that in recent years Main Street investors have only jumped back into the market after a big run-up in prices—such as in the spring of 2009 or early 2011.
Over the longer term, numerous studies have found that Mom and Pop tend to have the market-timing skills that would have made the late P.T. Barnum jump for joy—buying after the market is up and selling again after it has fallen. Investors sold heavily during the crash of 2008-09. They were selling all last year.
There are plenty of reasons to view this market with caution—yet again.
While the economy certainly seems to be recovering, much of this has already been reflected in higher stock prices. And while U.S. stocks may appear inexpensive compared with current earnings, that may be an illusion. Economists say earnings have been artificially inflated, both by the Federal Reserve's actions to drive down interest rates and by the federal government's enormous budget deficits. Deficits give the economy a short-term shot in the arm, boosting demand for companies' products, while lower interest rates have allowed companies to borrow cheaply at what are, in effect, subsidized rates.
When U.S. stock prices are measured against less-volatile yardsticks, they appear considerably less appealing. Yale University finance professor Robert Shiller measures stocks against average corporate earnings of the last decade, to smooth out short-term fluctuations. By this so-called Shiller or cyclically adjusted price/earnings ratio, the market is now at 23 times earnings—far above the historical average of 16 times, and a level usually associated with stock-market peaks, although the figure has been known to go higher.
Other economists compare stock prices with the theoretical cost of rebuilding those companies from scratch and replacing all their assets, a measure known as "Tobin's q," after the late economist James Tobin. By this indicator, too, U.S. stock prices are far above historical norms.
Historically, stocks bought at elevated levels on the Shiller price/earnings ratio or the Tobin's q and held for a decade have produced poor returns.
Still others note an ominous recent coincidence. While Main Street investors have returned to the stock market in recent weeks, insiders—such as corporate executives—have suddenly started cashing out at a heavy rate.
Ben Inker, the head of asset allocation for Boston investment firm GMO, which manages $100 billion in assets, says U.S. stocks and bonds are both heavily overvalued at current levels. Based on some simple calculations, his firm fears that investors in the main U.S. stock indices, including the S&P 500, will be lucky to earn anything in real, inflation-adjusted dollars over the next seven years.
Where does this leave the investor? Bonds look worse than stocks. Cash, too, is earning nothing, but at least it won't go down in a crisis.
Mr. Inker suggests investors stick to the types of investment that look the least dangerous right now: Top-quality U.S. blue chips, such as Johnson & Johnson (JNJ) or Coca-Cola (KO), European and Japanese stocks and those in emerging markets. In all three areas, he says, one can find better valuations.
It's only one opinion, but Mr. Inker's firm was among the few to predict the slumps that followed 2000 and 2007—and that also recommended buying stocks aggressively during the 2008-09 crash.
Mr. Inker believes the overall investment outlook today is even worse than it was in 2007, because even if stocks aren't quite as expensive now as they were then, bonds are more expensive. He fears the standard portfolio of 60% U.S. stocks and 40% bonds is actually likely to leave investors poorer, in real, inflation-adjusted dollars, over the next seven or so years.