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Perspective on the Market's Big Rise

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The last time the S&P 500 (SNPINDEX: ^GSPC  ) traded at current levels was December 2007.

Depending on how you look at it, that means either stocks are at their highest level in five years (good!), or they haven't gone anywhere in five years (bad!).

That's actually an important distinction to make. There are two big arguments among analysts right now. One says the market has gotten out of hand and is overvalued. The other says stocks are just getting back to normal levels as the economy heals and profits boom.

The distance between the two groups is intense. JPMorgan strategist Thomas Lee told CNBC yesterday: "We still don't find investors overweight stocks. ... There's still a lot of memories of 2008, and I think we still have a taint on owning stocks." On the other side, an article in The New York Times on how individual investors are jumping back into stocks led one commenter to conclude, "Reminiscent of the shoeshine kid giving Joe Kennedy a stock tip."

Who is right?

A total of $22 billion flowed into equity mutual funds and ETFs during the first week of the year -- one of the biggest inflows ever. More has likely come in over the last week. But context is needed: These big flow numbers come after investors added basically nothing to stocks for four years straight. By no rational measure are individuals heavily invested in stocks.

And January is almost always a big month for equity inflows as people make their annual IRA contributions. 2010 and 2011 -- both years in which equity flows were negative -- saw heavy inflows during the first few weeks of January. Even the annus horribilis of 2009 saw positive flows in early January. What we've experienced in the last few weeks is just a minor uptick in a multiyear trend. It's not yet clear that it's anything more than that.

The last decade has been filled with so many market crashes that people now seem to automatically equate "stocks near all-time high" with "irrational bubble." But in a market where prices are supposed to appreciate over time, all-time highs happen pretty regularly.  Since 1928 the S&P 500 has closed at a new all-time high 1,024 times, or 4.8% of all trading days:

Source: S&P Capital IQ; author's calculations.

And why shouldn't stocks be nearing all-time highs? Profits are at all-time highs. Dividends are at all-time highs. GDP is at an all-time high. Household debt payments are at a three-decade low. U.S. energy production is rising for the first time in 25 years. The housing market has stabilized. And, most importantly, valuations aren't anything wild. The S&P trades at 13 times this year's expected earnings and still has a dividend yield higher than what can be earned on 10-year Treasury bonds. As the Financial Times pointed out last week:

The earnings yield on US stocks (the inverse of its earnings multiple) is 6.8 per cent, more than the 5.89 per cent yield available on junk bonds, a new sign of the way in which the very low yields on offer in bond markets have distorted traditional perceptions of value.

This says more about the valuation of bonds than it does about the valuation of stocks, but it explains what's going on. People aren't necessarily buying stocks because they have inflated views of stocks' potential. They're buying stocks because they'll offer the greatest return potential among asset classes as the economy strengthens. It's a pretty rational move.

It's just unfortunate timing. Ever since the 2008 crash, it's been obvious how the relationship between stocks and individual investors would play out: People would avoid cheap stocks like the plague, then rekindle their love only after they rebounded, almost intentionally avoiding an opportunity to make a fortune.

Here's the average annual return on the S&P 500 you would have earned through yesterday if you bought on Jan. 1 of any of the last 22 years, adjusted for inflation and dividends:

Source: Robert Shiller; author's calculations.

The biggest takeaway from the market's big surge isn't that insightful, but it gets forgotten like clockwork: If you buy stocks when they're cheap, you'll do well. If you buy then when they're expensive, you'll do much less well. It's the same story again and again.


Read/Post Comments (4) | Recommend This Article (37)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 30, 2013, at 6:27 PM, fool3090 wrote:

    How true. It reminds me of real estate agents who maintain that it's not only the perfect time to buy real estate but coincidentally the perfect time to sell, despite these two conditions being mutually exclusive.

    While buying equities on the cheap requires amazing insight and nerves of steel, I would say most of lack either or both traits. Market timing is a tough way to make a buck. I'm still a big fan of dollar-cost averaging with set investments happening no matter what on regular intervals.

    Put the 401(k) on auto-pilot with a well-thought-out allocation strategy. Then, with your Roth IRA, pick up promising, beaten down shares (along with having a couple of solid, diversified achor ETFs or two like VIG -- long on VIG). The 401(k) will be your steady-as-she-goes strategy over the long term, picking up free money from the company match. Meanwhile, the Roth IRA can be the opportunity fund for higher returns and can build upon promising value stocks that year -- because there is always a good value stock somewhere, even when the market hits its next 5-year high.

  • Report this Comment On January 30, 2013, at 7:57 PM, Tomohawk52 wrote:

    When everyone is telling me about how X is a surefire winner, I run the other way. When "everyone" believes in some investment, you can be pretty sure that it's over-valued. :-)

  • Report this Comment On February 01, 2013, at 3:28 PM, tprooney3 wrote:

    Fool3090, I am also a fan of dollar-cost averaging, but I set aside a little money each month in a savings sub-account called my VIX40. As volatility rises, good stocks get beaten down. When the volatility index exceeds a value of 40, I clean out my VIX40 savings account and buy quality companies at discount prices.

    Dollar-cost averaging and discount-purchases. It is my Bogle-Buffet allocation model.

  • Report this Comment On February 02, 2013, at 2:42 PM, dgmennie wrote:

    Now that the DOW has just closed over 14,000, getting us back to where we were in 2007 (oh goodie), the bleating of the investment community has started up once again in ernest. How many of the gullible (Lucy snatching the football from an ever-trusting Charlie Brown) will be sucked in this time? With 60% and more programmed trading going on every day, where are the gains and who gets them?

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