Friday, May 17, 2013

As Stocks Hit New Highs, Market Is Headed Higher ... At Least That's What History Suggests

Let's take a break from all the bad news about our dysfunctional government this morning. For that matter, let's skip any discussion about the lackluster economy and ongoing high unemployment rate as well.

Instead let's talk about why believing that our best days lie ahead and therefore investing in the long term future success of America and our free market system has been, is and always will be the right idea for We the People.

While all the bad news keeps on coming, the market keeps hitting news highs regularly. It's getting to be a habit.

And the outlook for stocks is still very good for long term investors. There's plenty of upside left in this old bull. At least that's my view.

That said, predictions about the future are always dangerous, and I would add that that's especially true for predictions about the near term future of stock prices. The fact is that nobody knows what will happen in the short term, so let's all be mindful of that important truism.

With that caveat in mind, we are at record highs in the stock market, so now is a good time to reflect and review today's levels in comparison to historical market benchmarks. And what they indicate is that now is no time for long term investors to get timid about owning stocks. On the other hand, owning bonds, of course, is an entirely different matter and people may wish to consider redeploying some bond monies into stocks for the foreseeable future.

We Were Right is this week's Barron's cover story and is subtitled 'Record Dow---Last year we predicted the Dow would hit 15,000 in 2013. That performance may be just the beginning:'

"Barron's jubilantly joins the hoopla over Dow 15,000, having predicted it early last year. But the hoopla is haunted by one surprising fact: In inflation-adjusted terms, the blue-chip average is still well below its record high of Jan. 14, 2000.

Social Security checks are indexed to the consumer-price index, so why not the stock market, especially since stock returns often supplement pension money? The Dow's nominal close on Jan. 14, 2000, was 11,723, but given that the CPI has risen more than 37% since, the Dow's inflation-adjusted close that January comes to 16,088. That peak was challenged, but not bested, on Oct. 9, 2007, when the average hit its last nominal high—which in 2013 dollars, would be 15,732.

Ironically, that's a bullish indicator. Over the long run, the stock market beats inflation by a substantial margin, especially when you include reinvested dividends. So if past is prologue, this still laggard stock market should lead to above-average performance.

Over what period? Lower-than-average returns over five years are generally followed by higher-than-average over the following two years. And in both real and nominal terms, the five-year performance of the market is well below average, even with dividends reinvested.

Accordingly, the Dow has about four chances in five of being flat or higher over the next two years. It also has a 50-50 chance of vaulting above 18,500 over the same time-frame. . . .

(S)ince the market's more recent near-death moment, in early 2009, Barron's has been running periodic updates on the long-term record of the market using historical data compiled by Wharton School finance professor Jeremy Siegel, author of Stocks for the Long Run (see "Case Closed: Stocks Work," March 9, 2009).

Here's what the data tell us: The median returns on the stock market over five-, 10-, 20-, and 30-year periods, with reinvested dividends included, have been strongly positive, even after inflation. And the imperatives of simple arithmetic would therefore indicate that periods of worse-than-average returns would be followed by stretches of better-than-average, and vice versa.

While statisticians would refer to this as the "mean-reverting" tendency of stock returns, Barron's has dubbed it the stock market's rubber-band effect: Markets stretched on the downside will tend to snap back, as do markets stretched on the upside.

The market obviously is not nearly as stretched as it was in March '09. And the higher the market goes, the less useful these cycles become as bullish indicators. Once market performance approximates the median, the rubber band goes limp. And of course, as the market performance starts exceeding the median, the rubber-band effect becomes potentially useful as a bearish indicator.

But the rubber band still has some snap-back potential on the upside. The five-year performance from April 30, 2008, through April 30, 2013, remains enough below par to be a bullish indicator. As stock traders might ruefully recall, while the averages were already falling by the start of that period, the bear market had quite some distance to go. Since this five-year span crossed the dreaded "valley" of early '09, it's a good measure of the market's success in recovering from its near-death experience.

Our Feb. 13, 2012, cover story predicted 15,000 on the Dow by year-end 2013.

That success has been tangible, but subpar. In real terms, the five-year annual return, with dividends reinvested, has been 3.83%, compared with a five-year median return in real terms of 7.16%. In nominal terms, again with dividends reinvested, the five-year annual return has been 5.80%, compared with a five-year median return in nominal terms of 9.41% (see table below).

These calculations, and the numbers in the accompanying table, were generated by Jeremy Schwartz, research director of New York–based WisdomTree Asset Management and a former student of Siegel, who is also associated with the firm. Based on 142 years of market performance, beginning in 1871, he calculated returns for five-year rolling periods: 1871-75, 1872-76, and so on. He used the same method for 10-, 20-, and 30-year rolling periods. To simplify results, all the numbers in the table are on a nominal basis. At Barron's request, Schwartz also calculated two-year returns on the same basis to give us a nearer-term view.

He has found that the recent five-year inflation-adjusted return of 3.83% ranks in the lower two-fifths of all five-year real returns. Nominal returns have been higher in 46 of the subsequent 55 two-year periods, a positive prospect.

For all 55 of these two-year periods, the median return in nominal terms was 14.59%, compared with a median of 6.66% for all other two-year periods. To apply that 14.59% to the Dow, we subtracted 2.39% for dividends, leaving a median price return of 12.2%. Boost the Dow at 12.2% a year from the April 30 close of 14,839.80—the final number in our five-year interval—and you get a median target of 18,681.59 over the next two years.

Siegel ventures a more short-term outlook. Believing price/earnings multiples are likely to expand, he views "16,000-17,000 as within range by the end of this year."

The Odds Still Favor the Bulls
Whenever stock-market returns have stretched to an extreme, they've generally snapped back to equilibrium, with weak periods followed by strength and vice versa. While some five- and 10-year periods have been negative, all 20- and 30-year spans have been positive. Even with the market's recent strong performance, stocks are up just 5.8% a year over the past five years. That's well below the median return of 9.41%. Put another way, the odds still favor the bulls.

Equity Returns 1871-2012 (Average Annual) 5-Year 10-Year 20-Year 30-Year
Best 27.02%18.98%16.88%13.82%
Median 9.418.568.099.22
Worst -15.60-2.072.774.12
5-Year Equity Returns 4/30/2008 - 4/30/2013 5.80%
Source: WisdomTree Asset Management

Summing Up

History says the market is going higher.

So do earnings.

So does the U.S. economic outlook.

Besides, the concept of 'mean reversion' is real and this so-called rubber-band effect suggests that the market has considerable room left to rise in this investment cycle.

Now all that's required is for the government knows best gang not to screw things up too badly.

My bet is they won't. In fact, they may even be embarrassed enough by all the current political "news" (IRS, AP and Benghazi, to cite just three fiascos underway) to help and they can best do that by getting out of the private sector's way.

As a result, maybe they'll resolve to do no harm and allow entrepreneurs operating and investing in the private sector to work their magic on getting the economy moving and creating additional employment for our people.

So to my fellow long term oriented investors, let's continue to enjoy the ride to higher stock prices over time, although it will certainly be a bumpy one from time to time.

Thanks. Bob.

No comments:

Post a Comment