The Independent Market Observer

3/6/13 – Hooray for a New Record?

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Mar 6, 2013 11:49:57 AM

and tagged Market Updates

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Yesterday, the Dow Jones Industrial Average hit a new record, up from its previous all-time high in 2007. As I have mentioned before, new records are generally a sign of market strength, at least for a while, and can spur more buying as investors fear missing the boat.

Other supporting signs of market strength include new highs for the Dow Transports, the fact that the S&P 500 is less than 2 percent below its all-time high, and the general shift in narrative that I’ve discussed before, which also feeds off market gains.

As I said last month, the trend is clearly upward, and breaking the psychological barrier of previous highs should provide additional impetus. I wouldn’t want to bet against the stock market right now.

And yet, and yet . . . The first real caveat is that, in real terms, we’re not at a record at all. Stock prices are based on current dollars, which are worth less—thanks to inflation—than dollars were when previous records were set. In inflation-adjusted terms, the last record was in January 2000. Even though inflation has been low, over time it does erode the purchasing power of a dollar, so this isn’t just a theoretical or academic point. For the Dow to hit a real record, it would have to be over 16,000, up about 13 percent from yesterday.

Another caveat is that much of the gain was driven by a handful of stocks—IBM, Caterpillar, 3M, Chevron, and United Technologies. Because of the peculiarities of the Dow’s construction, higher-priced stocks make a bigger difference. As a capitalization-weighted index, the S&P 500 has its own quirks—namely, the higher the value of the company, the greater the weight. So Apple, for example, became more important as it got more valuable. As gains are concentrated in a handful of stocks, the index becomes less reliable as an indicator for the market as a whole.

There are positive factors as well. Index levels don’t account for dividends, and that offsets the inflation factor to a great degree. Conceivably, the Dow’s previous high now becomes a support level, making it harder for the index to decline.

Short term, the trend seems to be up. Longer term, earnings and valuation issues continue to lurk. We should know pretty soon whether the upward trend will continue or whether it’s time to take a break.

Technically, both indices remain well above their 50- and 200-day moving averages, and earnings continue to be projected to grow. Short-term valuations remain reasonable. I feel there is no apparent reason for a short-term decline.

Looking ahead, concerns remain. Longer-term value metrics show that the markets are overvalued. Historically, returns over three- to five-year periods from current longer-term valuations have been disappointing. In my view, there’s no real short-term reason to get out of the market at this point, but longer term, caution may still be appropriate.


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