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and yet another high

Scott Maxwell - Friday, March 29, 2013

The bunny brought along a early bit of goodness for the stock market’s Easter basket today with the S&P finally breaking into new territory, sometime after it’s cousin the Dow did the same. Over the past few weeks we’ve gotten a number of questions from clients regarding market valuations. Well, these questions aren’t exactly about valuations but follow the line of “Is the market too high? Are we ready for a big pullback?” And of course our answer is something to the effect of “Well that all depends”. Short and to the point right? Of course there is often a bit of follow through that sheds a little more light on things. So on a slow blog day, a sunny nice day here in Portland, I thought I’d share a recent answer to that very question.

Generally, overall, the stock market seems at a fair value. Stocks aren’t cheap like they were a few years ago and neither do they seem to be overly expensive. Stock prices are influenced by a number of factors. The primary driver over the long term is corporate profits and the growth in profits over time.

Imagine you are buying a company, say a lemonade stand on a busy corner. The company has one full time employee and after paying him/her earns 1,000 of profit in a year. It’s for sale for 3,000, or 3 times the annual earnings. This seems fair to you because in three years you’ll own the stand outright and all the profits going forward will accrue to you. The employee does the work and your investment will pay off over time.

Now imagine the same scenario but this stand is growing it’s profit by 20% a year. This stand has a special formula that everybody loves and there is the potential for opening several more stands and customers are clamoring for this product. This stand would sell for more than 3 times earnings, you might have to pay $10,000 (or 10 times earnings) for this business. It would be worth this higher multiple because it is growing its earnings and the outlook is exceptional.

Now imagine 1,000 businesses like this across the country. Every several months one of them is trading hands. Over time the price that one is expected to pay for those businesses becomes standardized. Given a certain amount of profit and a certain rate of growth it’s possible to figure out a price for any one of those businesses. Over time inflation pushes up the price of materials, labor and etc and those businesses cost more because of that (this is reflected in the price of the drinks that are sold). And over time the market that each of those businesses is located in expands with population growth and so those business grow (and hence cost more to purchase).

That is the stock market in a nutshell. And if inflation and population growth were pretty predictable so would the price of those businesses. Over longer periods those factors are predictable and they are factored into the market. And the cost of the businesses (stock prices) grow over time. But of course there are other influences as well!

Because the marketplace for stocks (businesses) is so large and liquid the price of those businesses competes with other sorts of investments (bonds, real estate etc). Also the expectations for growth change with the outlook on the economy. From time to time people panic (the sky is falling!) and the price of businesses (or real estate or whatever) get really cheap. That’s what happened in 2008. And from time to time people get too enthusiastic about the economy and the prices go through the roof (ala the late 90’s).

In reality stock prices are in constant flux because of these factors. People forget they are buying businesses and concentrate on this abstract notion of buying stocks. And stocks get cheap during times of pessimism about the economy and expensive when folks are sure that everything is going great guns.

Right now we’re in between those sorts of periods. Stocks are trading at about the long term average in terms of multiples of earnings (remember the lemonade stand). Right now people are paying about 16 times earnings to buy the great businesses of the world, real close to average.

Over time the pessimistic periods and the expensive periods average out but it can take a while for that averaging to occur. That’s why you hear that stocks have a long time horizon.  Folks that buy stocks when they are trading at about average prices tend to get average returns over time (not too bad!). When we are lucky enough to buy cheap (which is really hard to do because these are the darkest periods) folks get better than average returns over time. When folks buy at expensive periods they perhaps don’t do very well for quite some time.

So let’s just buy when things are cheap and sell when they are expensive! That is really, really, hard to do because it is so darn hard to predict the future. It’s difficult to buy when things are cheap because every fiber of our psyche is telling us to get out. Just like it’s hard to sell when things are going great.

Right now valuations seem to be pretty “normal”. The performance of the market will depend largely on how well the economy does. And while the economy is growing slowly it is growing, still on the mend from the recession of 08-09. There may be some periods going forward when some sort of calamity pushes prices down but on the other hand we may just have another couple of benign years as the economy grows and stock prices grow along with it. If that happens the market could go up quite a bit and shares will still be reasonably valued because earnings will have grown along with prices.

Still reading? It was a long winded answer I know. But it is a complicated story. And the truth is that no one knows just what markets will do from time to time. There are some indicators along the way of course, but they aren’t always clear. “No one rings a bell at the bottom” goes the old market adage and no one does at the top either. That’s why we diversify.

For now it appears that these new records are the result of inflation and a growing economy (with a number of other factors tossed in, but that’s another story). If stocks didn’t go up with inflation and corporate profits it wouldn’t take long before you could buy that lemonade stand for a song.

JP Morgan Chief Strategist David Kelly in an article on CNN tells the same story (but much more succinctly).

Have a Happy Easter!

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