Anatomy of a High Market — April 2013

April 22, 2013

Dow Jones Average: 14,567
S&P 500 Index: 1,563


Anatomy of a High Market


For the third time in the past thirteen years the S&P 500 stock market index has climbed to
a high of 1550. While the previous two trips to this particular summit were followed by a
steep plunge to the valley floor, it is hard to say if we will see a repeat of that pattern any
time soon. The complexion of the current move in stock prices is quite different from the
bubbly gains that culminated in 2000 and 2007.

The mood in the country and the financial markets was extremely positive when the
S&P 500 first reached the 1550 level in the year 2000. The U.S. was running a budget
surplus, international conflict was subdued, the Internet revolution was creating new jobs,
and real estate markets were firm. In this benign environment technology stocks caught fire,
driving the market indices to record highs. It was a bifurcated rally, with technology stocks
producing most of the gain, while many other stock market sectors languished. When the
buying fever finally broke in early 2000, the market leading, technology stocks unraveled,
putting a huge dent in the value of most investment portfolios.

While the 2007 peak in stock prices happened to be at the 1550 level again, it was far
more broad based than the tech-centric high reached in 2000. Almost every stock market
sector participated in the final move higher in late 2007. Some observers, including then
candidate Barack Obama, called it a false prosperity, built on credit expansion, a real estate
bubble, and dubious financial derivatives. But for most Americans it seemed that things
were okay, if not perfect, with the economy. The unemployment rate was relatively low and
most people were beneficiaries of rising home values. The bursting of the real estate bubble
in 2008 and the financial crisis that ensued took all sectors of the market down in a rather
uniform fashion.

In the first quarter of 2013, the U.S. stock market reclaimed the lofty level of 1550 first
reached in 2000. The recovery in stock prices was a long, improbable voyage, with the
market gains occurring during a period of worldwide economic malaise. Unemployment has
remained high, wages have been stagnant, debts too high, and revenue growth tepid at best.
High markets often correlate with an ebullient public mood, but not this time. Fear of the
future has been more pronounced than optimism during this market move. Ultra-low interest
rates and money printing by the Fed have sustained the rally.

By starving income-oriented investors for five years, the Federal Reserve has forced
would be bond investors into dividend paying stocks. The stock market has become a
substitute for the bond market. The companies leading the market are some of the largest,
most stable businesses, that pay above average dividends. Boring has become beautiful.
Stock prices for companies that sell necessities such as food, medical, and personal care
items have surged even though revenues at these companies have changed very little. At
first glance, a stock market supported by mature companies in the consumer and medical
industries seems more sustainable than the heady tech and finance driven moves of 2000
and 2007. But there are risks to the underpinnings of the current advance. The market is
one dimensional, completely dependent on the low interest rate environment. If a financial
bubble is defined as an extreme, unsustainable condition, the bubble this time has formed
around the expectation of zero interest rates forever. When interest rates return to normal
or even partially normal levels, the stocks currently driving the market higher will lose
popularity and the premium being placed on their shares will most likely evaporate.

Current Strategy

While major stock indices such as the S&P 500 and Dow Jones are at nominal (not inflation
adjusted) highs, the environment for investors is more complicated than one might imagine.
Investors expect to be doing well as market averages rise, but many stocks are actually
declining. The most economically sensitive industries, such as energy, steel, and heavy
machinery are being negatively impacted by weak global demand. Technology stocks
are an unpredictable sector, with as many notable losers as gainers. Strength in stock
prices is concentrated in the sectors perceived to be the most stable and insulated from the
macroeconomic environment. Food, consumer basics, telecom, and medical stocks are doing
well, with share gains greatly exceeding actual results at the companies. As long as investors
fear economic upheaval at home or abroad, and the Fed keeps pouring a trillion dollars per
year into the system, the current mix of strong and weak stocks is unlikely to change.

The portfolios we manage hold some shares in medical, consumer, and telecom
companies. We are planning to maintain most of those positions until there is some sign that
the interest rate picture is shifting. We consider these stocks to be holds at best, and certainly
will not be adding shares at current price levels. There may be buying opportunities in the
somewhat beaten down technology stocks, but one has to tread carefully in this unpredictable
sector. A number of smart, value investors are placing more money in markets outside the
U.S., because foreign stocks appear cheap relative to U.S. companies. We hold a number
of foreign stocks in portfolios, that have done well in spite of difficult economic conditions
overseas. We will continue to look at many industries, at home and abroad, for good buying


Return to Archive