Trying to pick the top in stocks? Good luck
“THEY don’t ring a bell at the top,” the old saying goes about bull markets.
But to some investors who believe the top is here, or near, Wall Street sounds like St. Peter’s Square on a big holy day.
To state the obvious right up front, the bears so far have been wrong, wrong, wrong, despite that loud ringing in their ears.
Their pain grew more acute Thursday, when the Dow Jones industrial average scored its biggest one-day percentage gain in nearly four years.
The Dow ended the week at a record high of 13,907.25, bringing its year-to-date advance to 11.6%. Not a bad return for less than seven months.
A week ago a reader e-mailed me with a long list of reasons the stock market was, in his opinion, far too risky to buy. And by definition, if it’s too risky to buy, it’s a good time to sell.
“How about the rising levels of mortgage defaults and foreclosures?” he asked. “How about interest rates rising around the world? How about the crashing dollar?”
His list went on: “The war in Iraq, our continuing budget deficit, hedge funds that are imploding, U.S. consumer debt at an all-time high.”
Factually, he was mostly correct. So why isn’t the stock market paying attention to those ringing bells?
It’s possible the market is caught up in a mass case of denial, similar to the experience of 1999 and early 2000 with technology stocks. Was it risky to pay 200 times earnings for a tech stock back then? Of course. But for an extended period people found ways to justify that risk with arguments that were obviously absurd only in retrospect.
The problem with fighting the trend in times of mass denial is that it bowls over everything in its path.
As the economist John Maynard Keynes once said, “The market can stay irrational longer than you can stay solvent.” That applies in both bull and bear periods.
Now, here’s the bullish case, in a nutshell: Investors aren’t being irrational about stocks, certainly not on the level of the tech mania. The simple reason the current list of market threats isn’t holding buyers back is that people have heard them all before.
The market already knows about budget and trade deficits, high consumer debt levels and the weak dollar. It even seems to be getting used to the idea that mortgage delinquencies could continue to rise for a long time.
To dim investors’ appetite for stocks, you may have to really shock them. Nothing this year has done that trick.
Most of the time, a bull market ends when investors begin to sense that something is seriously wrong with the economy -- something that will lead to a decline in corporate earnings, thereby undercutting the primary reason to own stocks.
There is no question that earnings growth overall is slowing from the astounding pace of 2004-06. But the numbers still are rising, and that is keeping investors interested.
Second-quarter earnings reports will begin to pour out this week. Total operating earnings (profit before one-time items) for the Standard & Poor’s 500 companies are expected to rise just 4.4% from a year earlier, based on analyst estimates tracked by Thomson Financial.
Even if companies beat the estimates, as they usually do, growth is likely to be in the upper single digits at best.
Is that enough to sustain a bull market? It is in the view of Stanley Nabi, who helps manage $8.3 billion at Silvercrest Asset Management in New York. Even 7% earnings growth would be “amazing” this long into an economic expansion, he says.
General Electric Co., often viewed as a proxy for the U.S. economy because it is involved in such a diverse mix of businesses, said Friday that its operating earnings grew 12% in the second quarter. GE projected growth of as much as 19% in the third quarter, based on what it said were “strong orders and momentum” in its businesses.
GE stock rose 50 cents to $39.50 on Friday, its highest level since 2002. The stock’s price-to-earnings ratio is about 18 based on analysts’ consensus estimate for operating earnings this year.
That isn’t dirt-cheap by historical standards, but it’s a far cry from GE’s price-to-earnings ratio of 47 at the stock’s all-time high of $60 in 2000.
So investors look around, and here’s what they see: The global economy continues to boom. The domestic economy has slowed, but it isn’t crumbling. Consumer spending has weakened, but it hasn’t collapsed. Stock prices relative to earnings aren’t outrageous, on average. Interest rates have risen, but from absurdly low levels two years ago. Takeover activity remains robust.
It isn’t terribly surprising that the stock market refuses to give much ground.
But when the Dow soars 2% in a day, as it did Thursday, it’s natural to be concerned that things are getting frothy. If your gut tells you it’s time to take some money out of the market, follow your instincts.
Making an all-or-nothing bet that the bull market has peaked, however, is a game only for the very brave. Even if you manage to get out at the top, good luck knowing when to get back in.
--
