Six things to mull as stocks break records

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  • Sentiment is frothy: watch out for irrational exuberance

    Sentiment is frothy: watch out for irrational exuberance


The post-election rally has taken stock markets to all-time highs. Readers know I am not a fan of making stock-market predictions, but the recent gains do raise some interesting questions.

Rather than offer up a silly and very likely wrong forecast, I prefer to share instead some thoughts that you might have overlooked. I hope you will find them useful.

Sentiment: has become frothy as the market has run up. One of the more interesting ways to track sentiment is to use the Wall Street Journal as a reference guide. Stock-market researcher Laszlo Birinyi notes that when new market highs are consigned to page C4 or otherwise buried in the back pages, it is still early in the cycle.

By the time it makes it to the front page, we might be getting ahead of ourselves.

After months of back-of-the-paper articles, here is Thursday’s front-page Journal headline: “Postelection Rally Lifts Stocks to New Heights.” The A1 coverage suggests that more investors are aware of — and participating in — the market rally. That might imply that a short-term retreat is due.

Valuations are elevated: markets are overvalued relative to historical averages. This may be true, but it misstates an important fact. Markets are rarely fairly valued. When stocks are undervalued, people can be too nervous to put capital to work; when they are expensive, they are reluctant to overpay.

Here is the thing about equities: pricey markets often become pricier, cheap markets often become cheaper. It is important to remember that markets are at fair value for only the briefest of moments. Then they quickly careen off course, staying cheap or overvalued for years at a time.

Earnings: it may be counterintuitive, but consider this: markets are forward looking and valuations look elevated sometimes because the economy and corporate profits have to catch up with prices. That is what the first three-quarters of this year were about: stocks prices were little changed as they waited for earnings to rise enough to justify valuations.

Then there’s the CAPE ratio: this is Yale economist Robert Shiller’s measure of cyclically adjusted price-to-earnings ratio. My colleague Michael Batnick crunched the numbers on CAPE, and he found that “over the past 25 years, the CAPE ratio has been above its historical average 95 per cent of the time. Stocks have been below their historical average just 16 out of the last 309 months. Since that time, the total return on the S&P 500 is over 925 per cent”.

In other words, CAPE is a useful guide to give you some ideas about future expected returns, but as a market-timing tool, it is of little use.

New market highs are bullish: we said this two years ago, but it remains true today. I am always astonished when I hear that new market highs are a reason to avoid equities. Of all of the many factors that have been demonstrated to generate returns, I believe momentum — and in particular, trend — is misunderstood by many investors. Think of it this way — which is the better way to generate gains, investing in markets that reach new lows or new highs?

The election is over: the chief executive officer of Southwest Airlines noted that bookings have risen since the election. Maybe this is because everyone is so enthusiastic about Donald Trump’s victory and his plans to cut taxes and roll back regulations. My guess is that this election — the most insane, bizarre, surprising, reality-show-of-a-car wreck of our lifetimes — left many people too exhausted to think of doing anything other than watching the spectacle unfold.

Regardless of who you supported, and whether or not America is or was or will be great again, many people are relieved that the race is over. People are returning to their regular lives, and that means working, travelling, spending and investing in the equity markets.

Barry Ritholtz is a Bloomberg View columnist.

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Published Dec 10, 2016 at 8:00 am (Updated Dec 9, 2016 at 6:50 pm)

Six things to mull as stocks break records

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