Why Have Market Prices
Continued to Rise?
Good Morning Relaxing Retirement Subscriber,
“Why have stock market prices continued to rise this year?”
This is the most common question I’ve received over the last few months. Unfortunately, as inconvenient as it may be, there is no single reason.
As much as the financial media would love to wrap this phenomenon in a nice neat bow with a simple answer, it’s much more complex than that.
If you would like a simple answer, here it is: there are more buyers than sellers!
Sound a little too simplistic? Just think of the market for single family real estate prices. When housing inventories are low, and there are a lot of buyers bidding for them, some are willing to bid higher to buy the house they want.
With respect to stock market prices, the question to ask is why have there been more buyers than sellers this year? Here are some of the reasons:
- Although at a sluggish pace for several years, U.S. economic output has continued to expand, and the price offered to buy any company’s stock is always based on what someone believes that particular company’s future earnings will be.
- The same is now true for Europe of late with their economic output growing substantially.
- Unemployment has steadily fallen, thus more are working and working longer.
- There have been virtually no signs of significant inflation.
- Interest rates have continued to hover at historic lows thus making the cost of borrowing cheap.
- The most important long-term factor: corporate earnings and dividends have continued to grow.
- And, the strong possibility of future tax rate cuts has many individuals and corporations postponing the realization of profits, i.e. choosing not to sell appreciated holdings right now at higher tax rates in the hopes of paying a reduced tax rate upon selling in the future.
As you can see from this limited list, despite what you hear on the news, there is never one single reason why market prices went up or down on any given day, especially given the millions of market participants all over the world.
The lesson is not to fall into the financial media’s trap of creating a burning desire in you to know “why” market prices have gone up or down on any given day. What market prices do on a day to day basis is irrelevant for you as a long-term investor.
But, Is the Stock Market Overvalued?
The second question that continues to be pondered is if the stock market is overvalued, and thus “due” for a correction. Given the daily pronouncement that markets have hit another “new all-time high”, or the “Dow broke through 23,000”, or the “S&P crossed over 2,500”, it’s normal to ask these questions.
Evaluated in a vacuum, stock market prices are above historic averages in relation to earnings.
Consensus forward earnings of the S&P 500 Index is currently at $140. At the end of the 3rd quarter, the S&P 500 Index closed at 2,519 which would make the price to earnings a tick shy of 18 times forward earnings.
Historically, the average has been 16 times earnings so, in a vacuum, you could make the argument that prices are high right now at 18 times earnings.
However, there is another factor in play which is rarely discussed in the financial media.
At the end of September, the 10-year U.S. Treasury yield was 2.33%, while the earnings yield on the S&P 500 Index was 5.56%, which means the earning yield on the broad stock market is almost two and a half times greater than treasuries.
Couple this with the fact that bond prices, and thus their value, can only go in one direction in the future, and that is down (when interest rates inevitably go up). Given this, it’s no wonder why stock market price to earnings ratios are higher than historic averages.
This in no way is an indication that equity markets won’t provide us with temporary corrections and crashes at some point. Of course they will. We fully expect and plan for them.
What this simply points out is that prices have to be looked at from many different angles in order to determine value.
As tempting as it is, making long-term investment decisions based on any prediction of short-term price movements is troublesome. Just look at the number of pundits over the last eight years who have been wrong in their assessment of stock prices being “dangerously” high only to be proven wrong time and time again.
Asset Class Price Variation
The second factor which you always have to be aware of is that the discussion of “market prices” and “valuation” assumes that the prices of all asset classes move in unison. They do not.
For convenience, the financial media rarely mentions the tremendous short-term variance in performance of different asset classes, instead choosing to focus solely on the Dow or the S&P 500 because of limited time to grab your attention.
For example, as of the date I’m writing this, the index of one equity asset class is up 27.5% this year while another is up 6.75%. That’s a difference of more than 20% in less than one year!
Combining the two together and forming a “market” average overlooks the fact that some asset classes may be undervalued currently, while others may be overvalued.
This is the reason why it is so critical, once you have determined the percentage of your Retirement Bucket™ that you should hold in equities for the long-term, to allocate and strategically weight your holdings to a diversified mix of asset classes.
The alternative is to attempt to predict short-term price movements and play the “market timing” game of buying and selling various asset classes at just the right time.
There is a very good reason why Peter Lynch said, “more money is lost anticipating market crashes than the crashes themselves.”
Committed To Your Relaxing Retirement,
The Retirement Coach
P.S.: WHO do you know who could benefit from receiving my Retirement Coach “Strategy of the Week”? Please simply provide their name and email address to us at info@TheRetirementCoach.com. Or they can subscribe at www.TheRetirementCoach.com.
I appreciate the trust you place in me. Thank you! (The content of this letter does not constitute a tax opinion. Always consult with a competent tax professional service provider for advice on tax matters specific to your situation.)