Stock Market Rally Shows The Perils Of Thinking Too Much

Commentary

The stock market is once again hitting new highs. But if you didn't foresee this latest ascent, don't feel bad.

You're certainly not alone.

"Nobody called it," observed John Rekenthaler, vice president of research at Morningstar, writing in the August/September issue of the company's investment magazine.

Actually, that statement probably isn't accurate, as Rekenthaler quickly noted. "Somebody, somewhere advised near the market's bottom (in early 2009) that investors load up on stocks," he acknowledged. "Not many, though."

It's not easy to make accurate predictions, even when those doing the forecasting are the sharpest and highest-paid people on Wall Street. The future is inherently difficult to foresee, and there are so many distractions that can lead to false conclusions.

Fear of the future

But more to the point, a lot of people have trouble blocking out negative headlines and envisioning the opposite – that things might actually get better. Maybe we like to fear the worst. For example, post-apocalyptic sci-fi thrillers have become a popular genre in Hollywood. But what's the last film you saw that outlined a richer, healthier and more robust future?

When improvements do occur in health care, technology, transportation, living standards and in other ways, we tend to take them for granted.

"Human progress occurs in some small way on a daily basis because a few billion people go to work and figure out ways to improve living standards," observed Jeremy Kisner, a certified financial planner in Phoenix, writing in a blog.

Individuals don't always recognize these gradual improvements. But investors overall eventually get it right through their collective buy-and-sell decisions in the stock market.

"People buy more things, companies grow and wealth is created based on billions of people living longer and better lives," Kisner said. "The stock market represents ownership in many of the largest, most sophisticated companies - the companies that are making human progress and higher living standards possible."

Inflation anxiety

The broad stock market, as measured by the Wilshire 5000, has risen around 340 percent since March 2009. Over that time, despite steady gains, there have been many reasons for investors to be cautious. The Great Recession was a still-fresh memory, including the housing bust and banking crisis. Then came a huge run-up in federal deficits, the European debt crisis and other problems.

Naysayers got unnerved by quantitative easing – the massive bond-purchasing programs pursued by the Federal Reserve and other central banks to stimulate economic growth at a time when they couldn't push interest rates any lower.

"To critics, of which there were many, the cure was worse than the disease," Rekenthaler said about quantitative easing.

Pessimists worried that the programs might trigger a surge in inflation and possibly lead to new pressures on the banking system, weakness for the dollar, declining consumer confidence and other fallout. Quantitative easing did push up federal debt – a problem that continues to worsen – but the other perceived dangers didn't materialize, especially runaway inflation.

Ongoing skepticism

The public gradually has warmed up to stocks, but not to the degree you might expect amid a nine-year bull run. A lot of people checked out of equities in 2007, 2008 or 2009 and never got back in.

"It is unfortunate that investors often get scared out of the market by negative headlines, or even worse, things they think might go wrong," wrote Kisner.

Many of those perils - the market's flash crash on May 6, 2010, downgrading of the federal government's credit rating, the European debt crisis and Brexit among them - have largely faded from view.

Meanwhile, thousands of mundane improvements that didn't make major headlines have gradually made the world a better place, Kisner noted. These include advances in medicine, improvements in automotive fuel efficiency, the advent of alternative energy and lower costs for almost every type of technology - even free Wi-Fi at Starbucks, he quipped.

As Microsoft co-founder Bill Gates once said, headlines can be misleading because bad news makes headlines, while gradual improvements don't. Investors who paid too much attention to negative headlines over the years have paid a price for it.

The profit trend

While the economic backdrop since 2009 has been mostly sluggish, the direction nevertheless remained upward. More important, corporate profits have been on a tear, with the recent cut in corporate income taxes providing a strong ongoing tailwind.

If there's one key catalyst for future stock prices, it's the trend in profitability.

Adjusted for inflation, the collective per-share earnings for the 500 large corporations in the S&P 500 index had exceeded $80 only in two prior years, 2005 in 2006.

"Since 2010, they have been above that mark every year, notching a record $111 in 2017," observed Rekenthaler. "U.S. companies have made money like never before."

This isn't to say all is well and that the stock market will continue to push incessantly higher. It won't – at least without some major bumps along the way.

That's why it's wise to pay attention to tactics that can make it financially and psychologically easier to stay in stocks or stock funds without worrying that you're taking undue risks. Here are a few:

Invest money that you won't need for at least a couple years - the longer the better. Stocks have shown a strong historic tendency to appreciate over time, but the gains come in fits and starts - and are influenced in the short term by what's making headlines.

Decide on an appropriate asset allocation or mix, such as 70 percent stocks and 40 percent bonds/cash, or 60 percent/40 percent or whatever. Then rebalance back to that mix every now and then by taking some profits in your winning assets and investing that money in your laggards.

I discussed rebalancing in a recent column.Take advantage of "free money" if you can, such as employer-provided matching funds in 401(k) funds and even tax breaks like the federal retirement savers tax credit, which encourages investing by low-income people.

If you think of your employer as sharing some of the risk, through matching funds, it might encourage you to hang tight when market bumps come along.

The stock market often moves in baffling ways, especially over the short term. The recent ascent likely caught a lot of people by surprise.

But the gains haven't come out of thin air. There is positive momentum that many people don't appreciate, and it's reflected in the new highs.

Reach Wiles at [email protected] or 602-444-8616.