Just how easy has it been to make money in the stock market these past five years? Consider this scenario. In January 2009 a savvy Canadian tucks away $5,000 in a newfangled Tax Free Savings Account, investing the money in a low-fee fund that tracks the U.S. market. Then he does the same each subsequent January. Assuming all dividends were invested, he’d have roughly $40,000 today, and that’s after inflation takes its bite. That’s an annualized return of about 16 per cent. Forget beating the market. Simply showing up was enough to turn in a hedge-fund-sized performance.
Of course, most investors did precisely the opposite. They bolted for safety in the wake of the 2008 crash, and then stayed there, apparently content to earn a meagre quarter per cent in interest on their savings accounts, or only slightly more by locking their money into a government bond or GIC. A recent Gallup poll found just 54 per cent of Americans own stock, near the lowest level in 15 years and down considerably from 67 per cent during the dot-com boom. The figures for Canada are even lower.
This is the great bull market almost everyone has missed. And it continues to roar. The Dow Jones Industrial Average, which tracks 30 American “blue chip” stocks, recently crossed the 17,000-point threshold for the first time ever. That’s more than 2½ times its 2009 nadir. The broader-based S&P 500 is nearing 2,000 points, or almost three times its 2009 bottom. Canada’s S&P/TSX Composite Index has doubled. Even the tech-heavy Nasdaq is within 15 per cent of its record-setting close at the height of the tech bubble. Yet another sign of Wall Street’s confidence: there have been more initial public offerings, or IPOs, of companies in the first half of 2014 than during the same period of any other year in the past decade.
Now, just as mom and pop investors contemplate jumping back in, a host of experts have suddenly turned bearish on stocks, predicting an impending correction or even a crash. They point to all sorts of red flags: swollen price-to-earnings ratios, declining trade volumes, a lack of market volatility and even a rally in shares of General Electric, which, the thinking goes, is the last company in the world that investors would froth over. But mostly the analysis turns on a suspicion that this bull market is somehow too good to be true, and that good things rarely last. “The higher stocks move, the more concerned I get about a day (or days) of reckoning,” Henry Blodget, the one-time dot-com analyst who is now the editor and CEO of the website Business Insider, wrote recently.
The truth is that trying to predict stock market outcomes is next to impossible. This bull run has proved more vexing than most, full of mixed signals and seemingly contradictory data points. Share prices have soared in the face of a sluggish global recovery, the eurozone debt crisis, China’s slowing growth and pitched partisan battles over U.S. government finances. Companies are healthy but the economy itself isn’t. Things are said to be improving but central bankers continue to hold interest rates near zero, more than five years after the global financial system collapsed. This last point is arguably the biggest X factor when it comes to explaining the stock market’s performance “We see it in our client base,” says Tom Bradley, the CEO of Vancouver’s Steadyhand Investment Funds. “The interest in buying a bond or GIC at these low rates isn’t very high. So people are almost by default moving into stocks. That’s driving markets and pushing valuations up.”
That all sounds ominous. But given all the chaos and unpredictability, there’s a steep price to be paid for overthinking things, too—namely missing out on one of the best money-making opportunities going. Despite the naysayers, there’s still good reason to believe it’s not over yet.
In their early stages, bull markets are often characterized by an abundance of fear. That was certainly the case with the last recession and its immediate aftermath, when it seemed like the entire eurozone might get pulled into the abyss by a few of its more profligate members. After finding its way out of the trough in 2009, the stock market’s rebound was interrupted by a stomach-churning 16 per cent pullback in 2010 and another one in 2011. But then, suddenly, the market switched into autopilot in late 2012 . By the end of 2013, the S&P 500 had clawed back all of its 2008-09 losses and continued to surge higher—a trend that has continued during the first half of this year. “The good things out there right now are that the big economies in the Western world look to be on a solid footing and are recovering,” Bradley says. “The big thing is that it looks like a disastrous unwinding in Europe—an ’08 or ’09 type of thing, is off the table. The relief of taking that away is helping fuel [stocks].”
Now, with the Dow and S&P 500 routinely setting new records, the fear is mostly one of re-entering uncharted waters. Oddly enough, one of the measures that’s causing particular consternation is an apparent lack of concern among investors themselves. As a market approaches a peak it generally experiences more frequent price swings as investors try to get a sense of whether the ground is shifting beneath their feet. Traders call the phenomenon volatility, and the most common measure of it is the Vix, a market-volatility index created for the Chicago Board Options Exchange. Sometimes called the market’s “fear gauge,” the Vix tracks the cost of buying options on S&P 500 companies—a hedging strategy that helps investors guard against swings in a company’s share price in the near future. When the Vix is low, as it is now, it suggests investors don’t see the need to protect themselves with options. But too little volatility makes analysts nervous, too. They worry that an extended period of calm amid rising markets creates a sense of complacency among investors and encourages risk-taking. Those who worry do have history on their side. The last time the Vix was at its current level was in 2007—right before the financial crisis hit.
There are other warning signs. Stock market valuations appear lofty. By one measure, the cyclically adjusted price-to-earnings ratio, the S&P 500 index is trading well above its long-term average (26 versus 16.5 times the average of the last decade of earnings) and is right about where the market stood before the crash in 2008. At the same time the number of shares being traded each day has plummeted from about 9.8 billion in 2009 to 6.2 billion last year, according to Bloomberg. People tend to worry about that, because it suggests the big, so-called “smart money” such as pension funds, is sitting this most recent rally out. So if they’re not trading, who is?
Well, the dumb money, or so the thinking goes. After pulling more than $400 billion from the U.S. stock market between 2008 and 2012, there’s now evidence to indicate retail investors are finally dipping their toes back into equities as the number of commission-generating trades on discount brokerage E-Trade’s system ticked higher in recent months. Just as tech-bubble investors made ridiculous bets on untested companies 15 years ago, some are questioning all the hype surrounding social media companies, with new names and dubious business models hitting the market each week. “Most of the people buying into those securities know very little about them, but they are buying them anyway and running up the prices,” says Maurice Levi, a professor of finance at the University of British Columbia’s Sauder School of Business. “People don’t want to be left behind.”
There’s no question that some corners of the market are characterized by exuberance. But it still doesn’t come close to justifying some of the doomsday scenarios floated over the last five years. In 2012, USA Today quoted three different forecasters who all predicted a hair-raising stock market crash on the horizon. Gerald Celente, a forecaster at the Trends Research Institute, warned of an “economic 9/11.” Harry Dent, author of The Great Crash Ahead, predicted—surprise—a great crash ahead and Robert Prechter, author of Conquer the Crash, first published in 2002 and later updated in 2009, compared the contemporary economy to the Great Depression’s. Sobering stuff. And, so far, all wrong.
There are a couple possible reasons for the misfires. The first is that there are big rewards for pundits who make extreme predictions—namely high-proﬁle interviews and, evidently, book deals. The second is that investors—including supposed experts—suffer from short memories. We’re more likely to recall the pain of the 2008 market crash, when nearly $11 trillion in market wealth was wiped out, than the U.S. economy’s long track record of resilience during other crises, like the rampant inflation and double-digit interest rates of the 1980s.
Investors also need to make sure they don’t get so preoccupied with data points that they miss out on the bigger picture, argues Jeffrey Saut, the chief investment strategist at Raymond James. He recently told Yahoo! Finance that he still believes we are in the early stages of a secular bull market, not unlike the one that ran from 1982 to 2000. His reasoning is refreshingly simple. “What people don’t understand is equity markets don’t really care about the absolutes of good or bad,” Saut said, referring to things like GDP growth and unemployment rates. “They care about whether things are getting better or worse. I think they’re getting better.”
That doesn’t mean another correction is off the table. Far from it. But, as with 1987’s Black Monday, which landed five years into the bull market of the 1980s and 1990s, people like Saut believe it will only be a short-lived affair. Of course, history suggests that when a correction comes—and it will—people will panic again and sell stocks because they fear losses more than they relish the opportunity to make money. Sage investors call such moments—even drops of 20 per cent or more over a couple of months—a buying opportunity. That’s what makes them wealthier than most.
There are other measures pointing to more upside in equities beyond just feel-good investors. U.S. employers added 288,000 jobs in June, pushing the unemployment rate down to 6.1 per cent, the lowest it’s been since 2008. The better-than-expected jobs report also helped erase lingering concerns about a surprise 2.9 per cent contraction in first-quarter GDP, with many economists blaming the pullback on last winter’s brutal weather. “The steady stream of positive June U.S. data continues, with the key report—hiring—the icing on the cake,” wrote Jennifer Lee, a senior economist at BMO Capital Markets, in a report. While Canada’s economic performance has been more middling—GDP growth essentially stalled in April at 2.1 per cent on annualized basis—the pickup south of the border is expected to eventually lift the fortunes of Canadian manufacturers and exporters who sell into the U.S. market. As well, corporate earnings, which are what the stock market is supposed to reflect in the first place, have also generally been on the upswing since 2009—thanks in part to the deep cost-cutting undertaken during the recession that ultimately made companies more profitable. With second-quarter earnings season under way, analysts polled by Reuters expect earnings growth of 6.2 per cent, returning to double digits by the end of the year. If the trend continues, it will lend credence to the stock market’s early optimism—it’s not called a leading indicator for nothing—and could even help set the stage for future rallies. After all, when the S&P 500 is measured against its pre-recession level in 2007, the market’s current spike doesn’t seem nearly as out of whack.
The case for continued bullishness still comes with that all-important caveat: interest rates. Central banks responded to the 2008 crisis and ensuing recession by driving interest rates down to near zero. When it became clear that alone wouldn’t be enough, the U.S. Fed went a step further and instituted a program of quantitive easing, which amounted to printing money. At its height, the Fed was buying $85-billion worth of government bonds a month from banks and other financial institutions—effectively injecting that money into the economy. But instead of just taking cheap loans to buy new dishwashers and cars, people also borrowed money to sink into real estate (particularly in Canada, which never experienced a housing crash) and stocks (the amount of money investors borrowed from brokers, known as margin debt, have hit records on both the New York Stock Exchange and the Toronto Stock Exchange), creating concerns about new bubbles in both countries.
That has put central bankers in both Canada and the U.S. in a tough spot, according to Chris Ragan, an associate economics professor at McGill University and a former special adviser to the Bank of Canada. A roaring stock market is a predictable response to a protracted period of low rates, he says, and future rate hikes are likely to have the opposite effect, all other things being equal. The question is when and under what circumstances those rate hikes come. “Central banks would love to get back to being boring,” says Ragan. “But we’re not there yet. They are goosing the system as much as they can with monetary expansion in an effort to stimulate aggregate demand, but they’re also hoping other parts of the market don’t overheat. None of this is easy.”
Wary of central bank bubble-blowing, the Bank for International Settlements, an organization made up of central banks and other international organizations, has sounded the alarm about “euphoric” financial markets. Meantime, U.S. Federal Reserve Chair Janet Yellen recently dismissed the notion that she would consider raising interest rates to ward off bubbles, but nevertheless did acknowledge “pockets” of heightened risk.
In some sense, then, betting on the stock market is not only a gamble on continued economic recovery, but also that central bankers won’t take their foot off the gas. While that might normally seem like a foolish wager when rates have nowhere to go but up, there has so far been precious little evidence to suggest it will happen soon. Unemployment remains above the long-term average and businesses have yet to open the taps on spending. Investors can also take comfort in the fact the U.S. Fed has managed to wind down, or taper, its quantitative easing program to just $35 billion a month without sparking a stock market sell-off. So far so good, in other words, although investors would be wise to keep in mind that central banks have often kept rates too low for too long in the past.
Investing has never been a risk-free endeavour. That’s certainly the case as this five-year-old bull market continues to inch higher. But instead of fretting about whether it’s too late to jump in, or bemoaning all the money already left on the table, a better strategy is to sit down with a professional and hammer out a realistic plan. And then stick to it. The trick, as every fund manager worth their Patek Philippe timepiece knows, is figuring out a way to manage the market’s darker side—not run screaming in the opposite direction.