May marked the seventh consecutive month of increases for the Dow Jones Industrial Average and the S&P 500. Since the end of October, the DJIA and the S&P 500 have increased just over 17% each. Over the past twelve months, the S&P 500 has increased over 27%!
Both indexes have hit new highs in the past month. If you were a technical analyst, you might think the markets have broken out on the upside and anticipate continued escalation (see 30-year chart below).
Maybe that will happen. However, the markets have a propensity to deliver the opposite of what most people are expecting. I think it is extremely premature to predict another long-term secular bull market like we experienced between 1982 and 2000.
I have probably written about this before, but it is important enough to repeat. As a rule, risky investments (stocks, bonds, real estate) are priced relative to the return you can expect to get from “risk-free” investments. If you can get a 10% return without taking any risk, then there is a very low likelihood you will take risk. At the end of the day, investors are rational and they don’t take unnecessary risk. Investors can act like idiots DURING the day, but at the end of the day they are usually pretty rational.
In 1982 when I was but a rookie in this business, T-Bills (risk-free) paid over 15% and you could earn 18% in a money market fund (technically not “risk-free” but very low risk). If you can earn 18% virtually risk-free, most investors will do exactly that and not take any risk. Consequently, the demand for risky investments was very low in 1982 and the prices of risky investments were also very low. The Dow Jones Industrial Average traded as low as 777 in August of 1982.
Interesting fact: In 1982, the 30 stocks that made up the Dow Jones Industrial Average included the following 14 companies: Allied Chemical, American Can, American Tobacco, Bethlehem Steel, Eastman Kodak, Inco, International Harvester, Owens Illinois, Sears Roebuck, Standard Oil of California, Texaco, Union Carbide, Westinghouse Electric, and Woolworth. These once powerhouses were either bought out by other companies or replaced by others that represent American enterprise today such as Microsoft, McDonalds, Wal-Mart and Walt Disney. It’s hard to get on top and even harder to stay there.
From 1982 through 2000, the “risk-free rate of return” gradually declined from 18% to almost 0%. As investors earned less each year by not taking risk, the propensity for them to do so increased. The prices of all risky investments gradually increased and we experienced a secular bull market for 18 years. The average annual return for the S&P 500 was over 18% per year for 18 years. During that period, an investor didn’t have to BE very smart in order to LOOK smart.
There were other factors which contributed to that bull market. Increased productivity due to technological advances helped companies become more profitable. Developments in medicine and biotechnology, the end of the cold war and globalization of trade all contributed to a robust global economy. But, in my opinion, the decline in the risk-free rate of return had the biggest impact on stock prices.
There are factors today which could lead to a robust economy as well. New methods for oil & gas exploration are making the U.S. less dependent on foreign oil (and maybe independent someday) as well as providing new jobs. Productivity continues to flourish thanks to expanding technology (cloud computing, smart phones, tablets, etc.).
However, there are several distinct differences between 1982 and today, the major one being that interest rates are at an all time low instead of 18%.
If and when interest rates rise, investors will be faced with tough decisions. With low interest rates, the choices seem easy. If you earn only .10% in a money market fund or .75% in a bank-insured CD, it doesn’t seem like such a bad idea to own shares of Procter & Gamble, which pays an annual dividend equal to just over 3%. But when interest rates are higher and investors can earn 3% in a CD, the decision to make an investment involving risk becomes more difficult.
Between 1982 and 2000, investors had the wind at their backs. Declining interest rates made it an easy decision to own stocks. From 2000 to 2013, there has been virtually no wind as the risk-free rate of return has remained basically near zero. Sure there were a couple of short stints where the Fed raised interest rates, but the net result is that the risk-free rate of return has remained near zero for the past 13 years. If interest rates begin to increase, it will be the equivalent of having the wind in our face. You can still get positive returns with the wind in your face. You just have to work harder at it.
For that reason, we feel the past seven months are NOT the beginning of a long-term secular bull market, but merely a nice rally in what has been a sideways market.
Meanwhile, the U.S. economy continues to plod along, improving slowly but improving nonetheless.
- Home prices hit bottom a long time ago and are increasing steadily.
- Home foreclosures continue to decline every month.
- The jobless rate continues to decline slowly as unemployment hit 7.5%.
- The U.S. is producing almost as much oil as it imports.
- Auto sales are up impressively versus the same time last year (thanks to a significant pickup in truck sales). I was in Sweden for several weeks a couple of years ago and did not see a truck. Not ONE truck. And I drove around a lot. Of course, I calculated that gasoline costs over $8 per gallon so maybe that could explain the “no truck” policy.
Anecdotal positive economic indicator of the month:
My dentist is busy.
One of the effects of a recession is a household abandoning discretionary spending. New furniture, vacations, and new cars… these are all items that can be put on hold when you lose your job and income is tight. Believe it or not, it seems that one of the items that people cut out of the budget during an economic crisis is their bi-annual trip to the dentist. That’s right. People figure that a little extra toothpaste is cheaper than a trip to the dentist. As a result, dentists get surprisingly “unbusy” during economic crises.
Beginning in 2008 and all the way through last year, my dentist recommended my teeth be cleaned every four months instead of annually. No, actually I think they had me coming in every quarter. I got the feeling that maybe I was making up for the dental patients who had decided temporarily to cut the dentist out of their budget. Not only did I have an appointment every quarter, but I also received a reminder text message AND an email from his office one week before my appointment. The day before my appointment, I received another text message and another email requesting that I reply confirming that I was going to show up.
Fast forward to today. There may be no correlation at all, but I think it is interesting that since the economy has picked up (slightly) and unemployment has declined (somewhat), my dentist doesn’t seem to need me anymore. He has forgotten who kept appointments when times were tough. I have been cast aside. No appointments. No text messages. No emails. No love of any kind anymore. Don’t try to tell my dentist our economy is in trouble. He is too busy to listen.
In December 2012, we announced we were increasing our allocation to equity because we felt the stock market had some upside potential once all the geo-political uncertainties were removed from the front page. And that is exactly what happened. For this entire calendar year, the largest financial scare on the planet occurred on the tiny island of Cyprus… and the stock market has steadily increased.
Since we have just experienced a 15%+ return in the stock market this year and we think this market is still a “sideways” market, we are taking this opportunity to reduce our equity exposure somewhat. However, we are maintaining and even increasing our exposure to equity in emerging markets, particularly in light of the recent sell off.
In addition, we are paying close attention to the duration of our bond portfolios. Although we don’t foresee a quick and drastic rise in interest rates, the quick increase in the 10-year Treasury Bond yield got our attention.
This information is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.