What’s Driving the Stock Market and Can It Continue?

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What's Driving the Stock Market and Can it Continue?

In May, BlackRock CEO Larry Fink told CNBC he was convinced equities were still fairly cheap and could realize 8 to 10 percent returns in the next 5 or 6 years, taking the Dow to the 28,000 area by 2019. Mr. Fink is a sober risk manager who runs the world’s largest investment firm. Why is he so optimistic? At a time when so many investors are expecting another market crash, what evidence is there that stocks can move higher?

Some believe the current run up in stock prices is nothing more than interest rate fatigue affecting investors who have no better place to put their money. The fear of the 2008 crash returning has finally given over to the disgust of earning less than 1% in money markets and short-term bonds. Unemployment rates are slowly coming down and the economy appears to be ever improving. The net outflow of money from the stock market finally stopped in late 2012 and the incoming cash has helped the market move higher. Passing the prior all time high of 14,107 on the Dow has convinced some investors who had been waiting for a clear sign to get back into stocks that the time was right.

Unfortunately for these investors, the easy money was already made in the market over the last four years when fears and disbelief kept their money on the sideline. The Dow rallied from a low of 6,547 in March 2009 to over 14,000 in March 2013. Corporate profit margins reached historical highs as expenses were cut to weather the recession. Stock prices may indeed still be undervalued but it is doubtful we’ll see the Dow double again in the next four years.

The argument that there is nowhere else for investors to go is hardly a legitimate reason for owning stocks. It seems many of them have found another place to go which only partially contain stocks. Investors are pumping record amounts of money into balanced mutual funds. Balanced funds often contain some stocks and bonds in a flexible allocation or some fixed guideline. According to data compiled by Bloomberg and the Investment Company, assets in balanced funds increased 3.6 percent from January to April this year, compared with 1.2 percent for those that only bought equities.

The return to balanced funds is typical of the period of healing which follows a bear market. Cash flows into balanced funds reached records in February 1994, when the S&P 500 was in the middle of a 417 percent gain, and in April 2004 as the market was recovering from the tech wreck of 2000-2002. Investors believe a balanced fund will cushion the fall if it turns out the market drops after they invest.

One case for continued optimism is investor preference for stocks of companies with earnings least tied to the economy are beating so-called cyclical companies. Bullish investors believe investor preference for stocks that do better in sluggish economies is a contrarian indicator. Individuals and mutual funds have poured money into drug makers and household-product suppliers, speculating they provide safety because their products are in demand whether the economy shrinks or expands. Outperformance by defensive industries has been a bullish sign for the S&P 500 in past bull markets, with the index gaining eight of 10 times over the next quarter, according to data compiled by JPMorgan.

All this caution is probably the best reason for optimism. Market tops have historically accompanied periods of euphoria and an extraordinary lack of fear. None of which appears to be present in today’s market. Fund flows will eventually switch from balanced funds to equity funds as investors lose their fear of stocks. The price of gold has fallen from its all-time high but at $1,300 per ounce still reflects a lot of fear in the market. Shares in the S&P 500 index currently trade at 18.6 times earnings. This level is below the average 25.7 multiple of the late 1990s just before the market fell in early 2000. Valuations appear to still be reasonable and perhaps Mr. Fink is not too far off the mark.

Rick’s Insights

  • Some believe interest rate fatigue is the reason investors are buying stocks again.
  • Investors poured more money into balanced funds than equity funds this year which is part of the healing process after a bear market.
  • Defensive stocks are out-performing cyclical stocks which is another sign of an early market rally.

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