The Dow Jones Industrial Average set a series of new all-time highs in early March, moving above 14,300. But whatever cries of joy there were on Wall Street, they was drowned out by warnings and notes of caution. Market analysts are now more likely to advise holding existing positions and even taking profits rather than buying into the bull market. But despite very real concerns about the underlying fundamentals, bears may be proven wrong this time.
Back in early 1999, when the Dow first crossed the 10,000 mark, there were huge celebrations not only among brokers and investment bankers but on Main Street as well. Special hats were made to mark the occasion and then-New York City Mayor Rudolph Giuliani came to the Big Board to bask in the limelight.
As the Dow continued its upward march through the year, eventually peaking close to 12,000, books on how the market index would soon reach 36,000, 40,000 and even 100,000 began to appear. With the market rising fivefold in the previous decade, everyone in America seemed to expect to get rich simply by watching their retirement accounts skyrocket.
Some of that optimism resurfaced in 2007, when the Dow, after hitting a nadir in 2002, nearly doubled in value and surpassed 14,000.
Economists have now become fond of noting that the major stock market indices, unlike all other economic data, are presented in nominal terms. When adjusted for inflation, the Dow remains below its previous all-time high, and in pre-World War II dollars the index has been effectively flat since 2000. In historic terms, moreover, since the 30 companies that make up the Dow are periodically adjusted to reflect the changing structure of the U.S. economy, weaker enterprises naturally move out of the index to give way to more viable ones.
But it is the fundamentals that worry analysts most, not the technical aspects of putting together the market index. Over the past decade and a half, the Dow rose to a record high twice, only to suffer staggering losses. The catastrophic scale of those market declines suggested the bursting of a financial bubble, not an orderly correction characteristic of a mature industrial economy. Such declines have frightened retail investors, as we noted in our February column. Older Americans are especially worried that they may be forced to retire early—as they were after the 2008 global financial crisis—even as their pension savings plunge.
Then there is the U.S. economy, which has failed to recover fully from the financial crisis. While the jobless rate has been going down steadily for over two years, it is still the highest it has been in two decades. House prices are weak, and even though 2 million homeowners escaped the negative equity trap in 2012, nearly 14 million, or 27.5%, are still underwater, owing more than their homes are worth.
Foreclosures will remain a drag on the housing recovery. Looking further down the road, even if the U.S. economy enters a robust recovery, there are questions whether it could be sustained when the Fed starts taking away its exceptional monetary ease it implemented over the past five years and the federal government stops massive deficit spending.
There are fears the United States has run out of sources of growth, and that other economic superpowers, notably China, are snapping on its heels. The U.S. share of global GDP is shrinking. All this may have negative repercussions for the stock market. After all, the Dow took off back in the early 1980s, and continued to rise through the end of the 20th century, as the Soviet Union entered its terminal decline and eventually collapsed while the U.S. emerged as the world’s only superpower.
Add to this longer-term concerns such as peak oil and rising temperatures. While it is not certain that the world is running out of hydrocarbons, oil prices have had an unprecedented run over the past 15 years. Similarly, while the source of global warming remains controversial, the changing climate has been identified by insurers as a major future source of future losses and by the Pentagon as a national security threat.
Wall of Worry
A dose of skepticism may be healthy. The stock market usually rises on a wall of worry, as is well known. But many of these economic trends could also be seen as beneficial for the stock market. For example, globalization has confirmed, not diminished, the dominance of the dollar as a reserve currency. The 2008 crisis, if anything, has shown that no alternatives exists, certainly not the euro, the yen or the yuan.
Over the past 20 years, moreover, as Chinese, Indian, Latin American and even African consumers became wealthier, and the ex-Soviet Empire opened up, U.S. companies have carved a solid position in newly globalized markets. American brands of consumer goods, transportation equipment, military hardware, services and high-tech have become household names in places where only recently they were unavailable and unknown.
China is now a vital market for Apple iPhones as well as for GM cars. In fact, the Detroit giant’s dominant market position in China has been one of the key factors helping it effect a turnaround after going into bankruptcy in 2009.
At the same time, the high jobless rate, while certainly a source for concern, has helped U.S. companies to keep their labor costs down. Lower labor costs, in turn, are playing a major role in the process known as in-sourcing, i.e. bringing production (and jobs) from China back to the U.S. The United Auto Workers union was willing to make concessions to the Detroit Big Three under pressure from rank-and-file workers, who feared finding themselves without a job in the current economic climate.
These factors have translated into strong profits growth for the corporate sector despite a sluggish U.S. economy—something that goes against past experience and is counterintuitive. Profits could rise further once the economy improves. Some companies are remarkably cheap, even while the Dow is setting records. GM is trading at a price-to-earnings ratio of 9, and Ford has an even lower P/E, while yielding over 3% in dividends.
Equally counterintuitive has been a decoupling of the stock market from the political mess in Washington. As Democrats and Republicans butt heads over everything from fiscal policy to department head nominations, the Dow’s ascent suggests that the dysfunctional U.S. government may have become irrelevant to the private sector.
While the Dow is at a record, another key U.S. index, the Nasdaq Composite, is nowhere near its all-time high of just over 5,000. And, while in nominal terms it has now reached its highest mark since the dot-com bubble burst, in real terms it is actually only about half its 2,000 mark.
But the high-tech revolution was clearly not a flash in the pan. True, many Internet companies were grossly overvalued back then and a majority has gone bust. But a large number survived, proving that investor interest in the information technology and the Internet was not unjustified, only exaggerated.
Some of the leading Nasdaq companies, while providing spectacular returns over the past decade, still have very manageable P/Es. And even those that seem costly, such as Amazon or Netflix, have an exciting earnings potential and a growing customer base. We are still in the early stages of the IT revolution, and U.S. companies have had an unsurpassed record of thinking up new ideas and turning them into global brands.