With American stocks reaching an historic high water mark last week, the feeling I now have reminds me of the days when I was the parent of teenage children. The challenge then was to encourage independence while still providing a dose of adult supervision. The only thing left beyond doing what I thought made sense was the exercise of sitting quietly and gripping the arms of my chair as tightly as possible. This sums up my approach to the stock market these days.
Not that it matters to buy-and-hold investors, but many out of curiosity would be wondering how much longer we can expect to see a continuation of sustained rises in market values. While American corporations made more money last year than in any year in history, stock prices are supposed to reflect the public’s perception of what future profits will be. What classic stock market analysis attempts to filter out are the effects of “irrational exuberance” on the one hand and “panic” on the other.
Since interest rates have long been considered the most influential engine driving corporate profits, factors that contribute to low interest rates are worth reviewing. Yields (interest rates) on bonds rose in January and then fell in February reflecting the shifting sands of turmoil in the world, but on the whole, they were still at historical lows. Fluctuating rates hardly matter when they are down in the 3 percent range at one level or another.
The good news about the financial crisis is that the world has been slowly recovering, so our Federal Reserve and now European central banks have been inclined to exert their influence to keep interest rates low. A greater impact on interest rates has been the sea of cash sitting in personal and corporate bank accounts, content to earn no money and, in fact, losing 2.5 percent per year to inflation.
The individuals with cash are the people who believed opinions like the Wall Street Journal’s prediction back in 2008 that our Federal Reserve’s bond buying program to replace the financial service sector’s collapse would lead to an imminent spike in interest rates. This hasn’t happened, and smart people are even now betting trillions on the continuation of low rates as they invest in 10-year government bonds paying less than 3 percent. Corporate financial officers sitting on cash, by comparison, just can’t find a better use than that cash at the moment for deploying those off-the-charts corporate profits.
Moreover, the flight to safety on the part of the world’s investors has made U.S. bonds comparatively attractive, plus the additional bonus of a rising dollar against other currencies. That flood of cash coming in our direction has contributed to the pressure keeping yields at historic lows.
Thanks to these low interest rates and the phenomenon of a continuing slow rise of the world’s economy, the current price earnings ratio of the SP 500 is at 20.4 times net earnings, which is way above the historical average of 15.5. However, that average applies to years when interest rates were two to three times the rate they are today, so how meaningful is a comparison with past history?
Fortunately, we armchair squeezers don’t have to worry about all these moving parts. If our forearms are starting to burn, we can always make a shift to large cap high dividend yield funds or even individual securities that offer annual yields as high as 3 percent. Which reminds, me: A housesitter supervising our teenage kids returned one night to what she described as “a housesitter’s nightmare” — an impromptu welcome-home party for my son after a soccer tournament in Europe. It took a few days to clean up the mess, but the experience is not unlike what the stock market can present from time to time — unpleasant surprises when we least expect them. Learn to go with the flow.
Steve Butler can be reached at 925-956-0505, ext. 228, or firstname.lastname@example.org.