Courtesy of Doug Short.
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As amazing as it seems, over 5 years have now passed since the market hit “bottom” at the end of the 2008 “Great Recession.” Since then, the stock market has delivered phenomenal performance – especially in the last few years.
But has the stock market “disconnected” from the realities in the underlying economy? Are companies really making enough profits to merit the 224.4% stock market rally we’ve had from the March 9, 2009, low point, through June 30, 2014 (including dividend re-investment)?
Let’s consider 3 key points:
- Economic growth during this 5-year post-recession “recovery” has been weak by any standard, as has been well documented here and by many other sources.
- Profits have seen steady growth, as I’ll show in a moment.
- The stock market has FAR outpaced both growth and profits, as I’ll show.
So what’s fueling this 224% (and counting) rocket-ship? Let’s look under the hood.
Are companies making enough money to justify stock returns lately?
Many factors affect stock prices, but one of the main ones is (and always should be) corporate profits. That’s intuitive, right? If the companies in the stock market are making loads of money, stock prices should go up accordingly, right? (Right).*
The table below shows that companies have indeed enjoyed some good, steady earnings growth over the past 48 months.**
The table also shows the stock market has gone completely crazy, far outpacing profit growth… especially in the last 2 years (as shown in red)!
In total, earnings have increased by about a 53% over the past 48 months (or about an 11% annualized compound rate). In dollars, using data from Standard & Poor’s, earnings have grown from $67.10 per share for the 12-months ending in June 2010, to an estimated $102.49 per share for the most recent 12 months.
Stocks, on the other hand, have increased by over 107% during that same 4-year period (or nearly 18% annualized, including dividend re-investment)!
So stocks have gone up by 107% when earnings have increased by only 53%.
The graph below makes the disparity even more clear – and reveals that the “disconnect” has been most pronounced since about 10/1/2011.
I’ve highlighted the last 4 years using thicker lines. You can see steadily rising profits, or “earnings” (depicted by the thick blue line). You can also see a skyrocketing stock market – especially in the 2 years 9 months since about 10/1/2011 (depicted by the red line).
Since 10/1/2011, earnings have increased by about 17.8% (or about a 6.2% annualized compound rate). Stock returns in the same 33-month period have totaled 89.4% (or about 26.1% annualized compound rate, including dividends).***
Sometime in 2011 – which was coincidentally (?) the last time the stock market has experienced any volatility at all – the normally similar “shape” of the “earnings” line and the “stock market” line separated. Actually, the “shapes” of the lines diverged in the Spring and Summer of 2011, as the markets took a tumble that coincided with the end of the Federal Reserve’s (Fed’s) so-called “QE2” money-printing program. Then, just after the Fed announced another program known as “Operation Twist” (on 9/21/2011), the stock market took off, departing from the earnings line in a significant way. Earnings have risen… but the stock market has accelerated into the stratosphere!
It could be that the stock market is predicting higher earnings over the next few quarters… and indeed, analysts project accelerating earnings growth later this year. From my vantage point, though, additional factors certainly appear to be in play.
What’s the “mystery booster”?
For a clue about the “mystery booster” that has propelled stocks since 2011, consider what the Fed’s “Operation Twist” was all about. In a nutshell, the Fed began buying longer-term bonds and securities in an effort to keep interest rates low (…in an effort to stimulate the economy).
How do you suppose investors reacted to these Fed-induced low interest rates?
The answer seems to be that investors finally began shifting money away from low-interest-rate bonds and into – you guessed it – the stock market… thus driving stock prices higher & higher. (Note: Fund flows data suggests this migration from bonds to stocks shifted into overdrive in 2013, but with a particularly heavy flow going into foreign-stock investments… which wouldn’t affect the S&P 500, which is an index of U.S. stocks; interesting).
The “mystery booster,” in my view, has really been investors’ willingness to continue buying more and more stocks – at higher & higher prices.
Of course, in my view, the Fed’s actions have heavily influenced those investor behaviors. So credit a major “assist” to the Fed for today’s stock prices that are now ahead of earnings, and probably ahead of where prices should be given the underlying fundamentals of the economy.
Editorial comment: The Fed’s job is NOT to influence stock prices… or even bond interest rates, for that matter (both of which are supposed to be “free markets”). And now we have Fed chair Janet Yellen making statements about whether certain stock sectors are too high-priced, and so on. Mind-boggling. The Founding Fathers must be rolling in their graves. Now back to our regular programming….
How long will investors fuel the rally?
Investors seem to have the perception, due to low interest rates, that they have few other alternatives other than to buy more stocks. Compounding the matter, the stock market’s extreme low volatility the last few years has served to perpetuate a feeling that buying stocks at higher and higher prices is “safe enough.”
How long will this last? Until the market sputters.
Anytime markets deliver such juicy (or “juiced”) returns, with so little volatility, a good “correction” is the best prescription to get the stock market back to a healthier, more sustainable level. A little volatility, or even a minor downturn could “shake out” some investors who really have no business investing so much of their portfolio in stocks anyway (because they underestimate the risk involved). I don’t mean to advocate for a correction per se (as if my “vote” would have any impact anyway), but I’m describing how I’ve seen markets handle frothiness and complacency about risk in the past, and I do happen to believe a “shakeout” would be healthy.
Earnings reporting season
Over the next 2 weeks or so, over 1,500 U.S. companies will announce their quarterly results for the period from April – June 2014. These “earnings reports” – and the markets’ response to them – will provide insights into how markets will perform over next several months or so.
Will we see the “earnings” line and the “stock market” line begin to converge? Stay tuned to this blog for more perspective in the near future!
For now, keep this in mind: The performance of the stock market during “earnings season” isn’t driven by earnings. It’s driven by how investors feel about and react to earnings. I quoted Benjamin Graham last month, and will use the same quote again here:
“In the short run, the market is a voting machine; but in the long run, it is a weighing machine.”
The long-term outlook
In the long-term, as my regular followers know, I’m fairly convinced the market’s returns from today forward are likely to be below normal for possibly many years, based upon (among other things) the fact that markets have already gone up so much. There’s a reason that “buy low, sell high” is a famous investing adage, and you don’t have to be a rocket scientist to perceive that the “easy” opportunities to “buy low” have already happened in this cycle. I know that’s not a terribly exciting statement to read, but I hope you’ll find some comfort in the following 2 facts about the investment portfolios I lay out for you in my monthly guidebooks:
- Take Time for This portfolios are built upon a robust, solid foundation – a “Retirement War Chest” – that’s not dependent upon the stock market for consistently positive, compounding, efficient returns.
- The “Retirement War Chest” allows us enough flexibility to capitalize on “Aggressive Growth Opportunities” from time to time – particularly when we’re able to “buy low.” And I do expect we’ll be able to take advantage of many opportunities along the way to “buy low” into “growth”-oriented investments – all while limiting risk by (among other things) limiting the dollar amount we place at risk (which also has the nice side effect of allowing a greater proportion of your portfolio to remain in the consistently compounding, efficient “Retirement War Chest”).
* Of course, stocks are also influenced by other factors as well (such as dividends, sentiment, etc.); but in the final analysis, a company’s stock price primarily reflects how that company is doing in the marketplace.
** I chose 48 months in order to get a look at the most recent phase of this nearly 5 1/2-year recovery (so far). I’ve excluded the 1st several months of the recovery in order to avoid the skew that those early “V-shaped” months would reflect. Otherwise, my start date 48 months ago is completely arbitrary).
*** The S&P 500 line on the graph does NOT reflect dividend re-investment, since the index does not include dividends. All calculations in this article do, however, include dividends.
© Adam Feik
Take Time for This
This article is for informational purposes and does not constitute individualized investment, financial, tax, or legal advice. See additional disclosures here.
