Dow 14,000: Are Stocks Expensive Now?

Dow 14,000: Are Stocks Expensive Now?


Dow 14,000! Now that the celebrations are over, it’s time to ask whether this is the beginning of another upward leg for stocks – which have had an almost unbelievably good January – or just a rally taking place amidst relief that none of the Doomsday scenarios we were all fretting about only a few months ago have materialized as yet.

First of all, let’s set the record straight. Thousand-point intervals in the Dow Jones industrial average have very little significance in real terms, whatever they may do to investor psychology. What is most crucial for many big investors and traders is whether the S&P 500 can break above the record high of 1,576.09 that it hit in the autumn of 2007, before the financial crisis hit.

For much of the “recovery," stocks have climbed the proverbial wall of worry, and that doesn’t seem likely to change any time soon. Sure, January has been a blockbuster month for stocks, which have recorded five straight weeks of gains. And not surprisingly, investors responded by putting more money into stocks than those who keep track of these things have seen in years. Indeed, in a few cases, it has been more than a decade: In the four-week period ended January 30, Lipper recorded that net flows into stock mutual funds totaled $20.7 billion, more than in any month since April of 2000.

In the perennial tug of war between the bulls and the bears, the former have clearly dominated so far. But there are a few clouds taking shape on the horizon that may mean the bulls don’t have it all their own way in the coming weeks.

First, there’s the economic news. No one was expecting the U.S. economy to post big growth rates in the final three months of last year, a period characterized by tremendous political and fiscal uncertainty. On the other hand, no one anticipated that it would shrink, as the first GDP estimate has revealed. If growth sputters, what will propel the stock market forward? After all, if you believe Pimco guru Bill Gross, stocks will return less than 5 percent this year – which would mean that we have already seen all the upside that 2013 has to offer.

One of the realities of this January Rally is that it is being driven as much by negatives as by positives: by what worried us last year that isn’t quite as much of a source of concern as it used to be. China? Doing a little bit better on the margin, with the economy less likely to be in for a hard landing. Europe? Fingers crossed; there’s no real improvement in the plight of the Eurozone’s “periphery,” but no imminent crisis, either. The pesky fiscal cliff? Well, we technically went over the edge for a bit, and while Congress hardly crafted a workable long-term solution, there is less angst about the coming budgetary deadlines (at least, for now).

Corporate earnings are the one positive at work in the calculus. Last week, 71 percent of the S&P 500 companies reporting topped analysts’ expectations, according to calculations by Thomson Reuters. With about half of the companies in the index having announced their results, fourth-quarter earnings are up 7.2 percent over year-ago levels, although Thomson Reuters expects that will decline to just under 4 percent by the time all the companies have finished reporting. While not awe-inspiring, that’s better than analysts had feared going into the earnings season, and an improvement over the “trough” earnings period in the third quarter of 2012.

For stocks to keep going, more investors need to be tempted to leave the sidelines, and it’s hard to see what would serve as the impetus for them to do so. Nobody is expecting the next crop of economic data to offer much of an incentive: Odds are that productivity, key to generating corporate profits as revenue growth remains harder to come by, will prove to be disappointing. The best earnings performance will likely prove to have come from the banks, which have finished reporting. Instead, oil and gas exploration companies and insurance firms will begin announcing their results, which analysts don’t expect to be as alluring.

That all suggests that investors’ newfound confidence in stocks will be tested by a correction – of how much, lasting how long, it is impossible to say. Still, in spite of the rally and the fact that major indexes are within a whisker of breaking over five-year-old records to register new highs, the market seems reasonably valued (with a handful of exceptions).

Indeed, if you’re looking for a bubble, the place to start might be the corporate bond market, especially the lower end of the quality spectrum. As the Federal Reserve’s policymakers have kept a tight lid on interest rates, and investors have become ever hungrier for yields, issuers with “junk” credit quality have been able to raise new debt at an increased rate. Even before 2012 was over, a record amount of new junk issuance had flooded the market, with September being the single best month in the junk bond market’s history for new issuance. And within the junk bond market, as Steve Romick, portfolio manager of FPA Crescent Fund pointed out last November, the proportion of those issues with a “C” rating or without a rating at all has climbed, indicating a worrying degree of risk acceptance on the part of investors craving yield. “It is going to be a very ugly time when these things begin to unwind,” Romick said last year.

Without a crystal ball in hand, it’s impossible for Romick or anyone else to predict when that might happen or what might trigger it – but there is a widespread acceptance that this prolonged period of ultra-low interest rates can’t last forever, and that in many ways it offers a far greater risk to investors than a stock market that might, temporarily, have run ahead of itself in what to some will feel like the nosebleed territory of Dow 14,000-plus.