Gauging the market in the short- and long-term
By CRAIG HOELZER and JAMES C. STEELE

 

Will the stock market be higher five years from now? Ten years from now? What will make it rise?

These are questions we frequently ask people and are amazed at the responses. Most people say the market will be higher but few have any idea about what will make stock prices rise.

This is startling when you consider how much of the average person’s money is being directed into stock investments. Investors should have at least a basic understanding of what influences the movement of stock prices. The emotion of the day will move the market in the short-term but fundamental economic factors determine its direction in the long-term.

History can provide a guide for which factors are important when looking for market direction.

 

Earnings, interest rates

The most common answer to the question about what moves the stock market is
corporate earnings. Earnings are certainly a factor but not the most important one. To illustrate this point, let’s look at two very different market environments: the 1960s and 1970s bear market and the 1980s and 1990s bull market. From 1964 to 1981, the Dow Jones industrial average went from 874.12 to 875 for a measly 0.1 percent gain in 17 years. In the subsequent 17-year period from 1981 to 1998, the Dow went from 875 to 9181.43 for a gain of 949 percent. The reason for this dramatic difference was not earnings. In fact, the gross domestic product grew by 371 percent from 1964 to 1981 while it only grew by 180 percent from 1981 to 1998 (U.S. Department of Commerce, Bureau of Economic Analysis). The pace of economic growth was double during the period in which the market barely went up. The bigger factor was interest rates. The interest rate on a long-term government bond went from 4 percent in the mid-1960s to more than 13 percent in the early 1980s. By the late 1990s rates had dropped to 5 percent. The direction of interest rates has a huge impact on the movement of stock prices. If rates were to rise steadily over the next several years, the market could struggle.

 

Valuation

The valuation of the market as it relates to interest rates is another key factor to consider. One of the more common measures of stock market valuation is the price-earnings ratio,
or P/E ratio. A high P/E ratio indicates the market is relatively expensive when
compared to the historical average. A low ratio indicates the market is inexpensive when compared to the historical average. Going back to our previous example of the 1960s and 1970s bear market, the P/E ratio of the market contracted as interest rates rose. Corporate earnings were growing but stock prices were not rising so the market was becoming progressively less expensive. By the early 1980s, the broad stock market was downright cheap. The trend reversed in the 1980s and 1990s as interest rates steadily dropped. Stock prices rose and the market became progressively more expensive. By the beginning of 2000, the P/E multiple of the market had reached an unprecedented level. The result was a bubble in technology stocks followed by a market collapse.

 

Leverage

The steady decline in interest rates through the 1980s and 1990s meant that borrowing costs dropped. Investors were encouraged to borrow money at low rates and buy more
financial assets. This is leverage. Leverage can be a powerful tool when rates are
dropping and assets are appreciating. However, when borrowing costs rise and asset
values drop, leverage can magnify losses. The current sub-prime mortgage situation is a
perfect example of this. Leverage can play a role in the movement of stock prices too.

Through the 1980s and 1990s, the steady flow of borrowed money into the stock market
contributed to the extreme valuation expansion witnessed in the late 1990s. The disruptions we see in the credit markets today have made leverage more expensive and
less available. If these conditions persist or worsen, leverage could be reduced and
capital could flow out of the market putting pressure on stock prices.

So, will the stock market go up in the long run? The answer depends on how far into the future you look and at which market.

 

 

	Craig Hoelzer is senior vice president of wealth management and a financial adviser at Citi Smith Barney in Mount Kisco, N.Y. Reach him at craig.hoelzer@smithbarney.com.
	James C. Steele is vice president of wealth management at Citi Smith Barney in Mount Kisco. Reach him at james.c.steele@smithbarney.com.

 

 

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