Stock Market at New Highs!

Posted on June 18, 2014 by Dr. David Edward Marcinko MBA

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Is this a Bubble?

[A SPECIAL R&D REPORT FOR THE ME-P]

By David K. Luke MIM, MS-PFP, CMP™ [Certified Medical Planner™] http://www.networthadvice.com

David K. LukeThe market news has been replete with the phrase “new market high“ in the business news every couple of weeks as of late. The corresponding message is often that the stock market is likewise in a bubble. The S&P 500 index and the Dow Jones Industrial Average index are at all-time highs. The indexes have surpassed the 2007 peak.

The reality is however that the S&P 500 is up less than 6% from the beginning of the year, and the Dow is up about 2%. Most investors, of course, do not invest just in these two indexes, as these two indexes represent very large capitalized companies.

I am reminded of the customer in 1995 when I worked at a national brokerage firm that called me to liquidate his entire stock portfolio. “The stock market was too high,” he said. He was 5 years too early.

Risk Mitigation

Most investors will have a diversified portfolio that includes mid-cap stocks, small-cap stocks, and international stocks as well as large cap stocks such as found in the S&P 500.

Of course, these equity investments are also typically subdivided into the broader categories of “Growth” and “Value.” Which means most investors that believe in diversification will own four different “types” of stock, each divided into two different categories for eight different baskets of stock if you will. The typical daily news will focus only perhaps on the S&P 500, which is a portfolio of large capitalized growth stocks. This is only one of the eight different types of stock that an investor would typically own.

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In strong bull markets, typically all eight categories of stock go up together with some degree of correlation. This is also true in strong bear markets with all eight categories of stock going down in some degree of correlation. Portfolio managers typically try to offset high correlation of investments by owning investments in asset classes that typically do not all correlate together. This is a major technique used to reduce the volatility in an account.

However as you can see so far this year, most all of the eight stock indexes with the exception of small-cap growth are up slightly in line with the S&P index.

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[As of June 13, 2014] 

Name Ticker % Total Return YTD % Total Return 12 Month
Large Cap iShares S&P 500 Growth IVW 5.59 22.55
iShares S&P 500 Value IVE 5.76 18.39
Mid Cap iShares S&P MidCap 400 Growth IJK 2.69 18.24
iShares S&P Mid-Cap 400 Value IJJ 7.66 23.19
Small Cap iShares S&P Small-Cap 600 Growth IJT -0.52 20.8
iShares S&P Small-Cap 600 Value IJS 2.3 21.37
Foreign Large Blend iShares Core MSCI EAFE IEFA 3.75 19.25
Barclays Aggregate Bond Index iShares Core US Aggregate Bond AGG 3.26 2.39

Source: Morningstar

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Inflation

The buying power of the US Dollar has changed over the years. The Consumer Price Index (CPI), a common measure of inflation, has averaged around a 3% annual increase from 1913 – 2014 according to the U.S. Department of Labor Bureau of Labor Statistics.

In fact, an item purchased for $5.00 in 1913 would have a cost of $119.73 today, or a cumulative rate of inflation for the past 100 years of 2,294.7%. The cost of living rising each year is a safe bet. Inflation has increased every year in the past 50 years with one exception: 2009 when inflation fell -0.4%.

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Update: 06/17/2014 04:10 ET

[Market Update]
Symbol Last Change
DOW 16,808.49 +27.48
NASDAQ 4,337.23 +16.13
S&P 1,941.99 +4.21

Conclusions:

  1. The Market Indexes at new highs does not indicate a bubble. In fact, the market should, relatively speaking, regularly be hitting new highs because of the consistency of positive inflation. Prices of goods and services today are at all-time highs. Does that mean we are in an “inflation” bubble? No. This is normal.
  2. The S&P 500 is not an accurate measure of the US economy. While the S&P 500 is the common “market” indicator in the US, only about 55% of the earnings of the index come from the US. (Source: RBC Capital Markets Research, Capital IQ 2012). This is because mainly large multinational companies such as Google, IBM, and Apple that have a significant amount of overseas revenues weight the index.
  3. The S&P 500 or the Dow Jones Industrial Average (DJIA – 30 stocks) is most likely not an exact reflection of your personal stock portfolio, which would expectantly be more diversified. A typical well-diversified long-term investment portfolio would include not just large cap stocks (such as found in the S&P 500 or DJIA), but mid, small, and international stocks from the growth and value camp, as well as a diversified bond holding.
  4. Overpriced stocks, just like overpriced real estate, are more prudently ascertained by value measures, not simply by raw index numbers. A stock hitting new highs could still be quite undervalued. Meaningful variables such as earnings growth, price to earnings ratio, dividend yield, price-to-book, price-to-sales, and other metrics should be considered.

Conclusion

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