Is the Dow's All-Time High a Good Omen -- or a Warning Sign?

Five and a half years ago, the Dow Jones Industrial Average (DJINDICES: ^DJI  ) set an all-time record high of 14,165 points before sliding into the second-worst bear market in its history. Yesterday, the Dow broke its record, nearly four years to the day from the start of its rebound. Memories of that long fall still linger, staining the perception of those who endured it and tempering the optimism of all but the most fervent bull. Doomsayers are to be expected this far into a sustained rally -- which, at more than 1,000 trading days with no real correction, has now run well ahead of both the median and average length of all bull markets since the Dow's creation. But does this market really deserve the distrust, fear, and outright anger many investors have shown toward it as it continues to defy calls for another crash?

It's important to have a little perspective. The Dow set a record yesterday strictly in nominal terms, not accounting for inflation or the dividends paid out by its components. However, if you had instead bought the Dow's total-return index (which accounts for reinvested dividends) when it reached all-time heights in 2007, you'd have been back to breakeven a little more than a year ago. This same investment produced a 17% gain from the 2007 peak to yesterday's fresh "all-time record" in the standard Dow index.

Nominal growth and real growth are not quite the same thing. Inflation is (almost) always chipping away at the value of a dollar, so a 17% gain is really more like a 7% gain in real terms. A gain is a gain, no matter which way you slice it. However, without those dividends, the Dow would still be 8% lower than its 2007 peak in real terms and about 11% lower than its real dot-com-era peak. It's easy enough to find reasons for both optimism and pessimism when it comes to fresh records in stale indexes -- after all, in an equivalent 13-year period during the last great bull market, the Dow grew by nearly 600% without the aid of dividends.

This covers what happened. But it doesn't explain why -- or, more importantly, tell us what might happen next.

Background on the bull
This market is so mistrusted that, even at a record high, the Associated Press ran a story promoted on Twitter with the tagline, "Why don't many Americans feel more cheerful about the Dow's rally to a record-high close?" The story itself offers plenty of explanation: frustration over missing out, falling real income, higher taxes, a still-weak housing market, and a tepid employment environment.

These are all valid concerns. A Bloomberg report published three months ago found that Americans missed out on $200 billion in stock gains by sitting on the sidelines, and fewer than half of households owned mutual funds, which make up the foundation of most 401(k) plans. Real median household incomes were actually lower last year than they were just after the Dow bottomed out in 2009. At these levels, real median household income isn't just lower than it was in 2009; it's actually lower than it was in 1989. The elimination of the Social Security payroll tax cut this year is also taking an additional $1,000 chunk out of every $50,000 of gross income -- which is a great deal more than what 12 million-plus unemployed Americans are likely to earn this year. Home prices remain 20% lower than they were at the Dow's peak, and housing starts, though in recovery, remain 14% below their 2007 levels. Half of American states saw more foreclosures last year than they did in 2011, as 1.8 million homes across the country received a foreclosure notice.

Whether valid or not, these concerns can all be rebutted. Record-high corporate profits have made business a buyer of its own shares, resulting in nearly $400 billion in buybacks last year. Home prices and housing starts have both risen in the past several months, with housing starts enjoying a 25% year-over-year uptick and existing-home sales posting double-digit year-over-year price growth in the fall. Banks are doing everything they can to reduce foreclosures, and layoffs in the banking industry are now being attributed to a reduced need for foreclosure processing. As far as being mad that you missed out on the rebound goes...well, that's no one's fault but your own. Most retail investors underperform because they're too readily driven by fear and greed at the wrong times.

Tax increases, somewhat counterintuitively, may actually drive further market gains. Tax policy expert Bruce Bartlett recently published an article that found a pattern of bull markets gaining steam after tax hikes. Two of the greatest bull-market runs in modern history began after George H. W. Bush broke his "read my lips" pledge in 1990 and after Reagan's Tax Equity and Fiscal Responsibility Act became law in 1982. Hoover's tax hike in 1932, FDR's major hikes in 1935 and 1942, and Clinton's tax increase in 1993 also saw more market growth after implementation than would have been expected. Bartlett theorizes:

Insofar as taxes affect the market, I have long suspected that when tax rates are low they make it too easy for investors to get an adequate after-tax return. When rates rise, they must work harder for a higher before-tax return to compensate for the higher taxes. This pushes money into growth sectors.

Severe and persistent weakness across a number of economic metrics can easily explain why it has taken so long to get back to even. A recovery -- slow though it may be -- also explains why the market continues to grow despite widespread mistrust. There are several reasons why this recovery might fall apart, e.g., Europe, China, inflation, shrinking corporate profits, or another financial crisis possibly tied to student loans or subprime auto loans. These are all some of the red flags I've seen bandied about, but I'd like to instead take a quick glance at one obvious but overlooked reason to step lightly into the market now.

Bullish fundamentals and bearish realities
There's no one surefire indicator that points to an imminent market reversal, but there are some easily understandable fundamental metrics that can help provide clarity. The duration of a bull market, which I mentioned earlier, has little relationship to its ultimate gain and little influence over when it ends. What matters more are marketwide valuations, which have been best calculated by Robert Shiller with the cyclically adjusted P/E ratio. The CAPE has shown to have a 0.77 correlation to the movement of stocks since 1881, tracking performance far more closely than most other marketwide metrics. That's important to understand, because only a few other bullish periods come close to the current one in terms of valuation expansion.

Bull Market CAPE Growth | Create infographics.

While this bull market has experienced less growth in CAPE than six other periods, it's still the seventh-greatest CAPE expansion of any bull market in the Dow's history. However, what may be more important is the actual CAPE that a bull market starts with, versus its final valuation before a reversal.

Starting and Final CAPE | Create infographics.

Only two market periods ended with a higher final CAPE than the market has right now, and only one of them began with a higher CAPE as well. The 1920s and the 1990s were both great times for investors, but both were followed by extended periods of poor index performance. Growth will be sustainable only if investors continue to believe in the potential of many stocks even as they continue to reach multiyear valuation highs, or so long as earnings continue to grow. Most likely, it would take a combination of both factors. It could happen, but it may not be in the cards for 2013. FactSet's latest earnings insight now sees more than three times as many instances of negative earnings guidance as it does instances of positive guidance for this quarter.

What do you think about the Dow's new record? Will this be the year the Dow rallies past its real heights for good, or will we have to endure another long decline before things turn up for the long haul?

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