Market Reaches New Highs: Onward and Upward?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Sep 21, 2018 1:59:04 PM

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market reaches new highsI should go away more often. While I was on the road, the market hit new highs and looks set to go even higher. This move is kind of a surprise, given the extensive discussion of the trade war, the political turmoil in Washington, the worries about the emerging markets, and on and on. What’s happening, and is it likely to last?

Markets are responding to the fundamentals

The short answer is that when things are good, the market tends to rise. Economically, things are good. You’ve all seen the headlines. GDP growth last quarter was strong; this quarter is likely to be solid as well. Job growth also continues to be very strong, unemployment is at boom levels, and layoffs are at all-time lows. With the labor market healthy, consumer confidence has moved back to dot-com levels, and people are both able and willing to spend.

Business is also investing, forced to do so by strong demand and lack of labor. Even government is pushing the economy forward, with the tax cuts and increased spending. From an economic perspective, the tailwinds are substantial. This environment won’t last forever, of course. But while it does, the effects can be significant—as we are seeing. Markets are simply responding to the fundamentals.

Earnings and valuations

Another way to look at this is to simply decompose what stock prices actually consist of: earnings and valuations. When earnings go up, so should stock prices if valuations remain constant. If valuations go up, you can have a double whammy of growth. Right now, earnings are rising and valuations have stayed steady, so stock prices are going up. It really is as simple as that.

The connections between the two are the economic fundamentals (which drive earnings growth) and confidence (which drives valuations). To try to figure out whether the bull run can continue, that is what we have to look at.

The fundamentals remain good. All of the major economic signals are still green, as we covered at the start of the month. The expansion continues. Although it is likely to slow a bit from the strong second quarter, growth should still continue above the levels of recent years for the next couple of quarters. This growth should continue to support the market.

Confidence, though, is tougher to predict. On the consumer side, it continues to be very strong, at the highest level since the dot-com era. On the business side, it also remains healthy, but here there has been some recent weakness that suggests business might not be as fired up as the consumers. Fortunately, consumer confidence is a better predictor of market valuation levels—so here the news is good. Right now, and based on expected earnings over the next year, stocks are close to the lowest valuation level of the past several years. If valuations simply hold at this low level and earnings rise, we can expect to see rising stock prices. If valuations rise back to the upper levels of recent years, we might see even more appreciation. Either way, the levels of confidence and valuations we have seen in recent years should continue to at least support stock prices and probably push them higher.

Will the good times last?

These conditions won’t last forever, of course. If I had to guess, the strong confidence and valuation levels will persist until the economic fundamentals roll over. At that point, we will see the headwinds take over. In the meantime, though, the trend looks likely to keep pushing stocks higher. Let’s hope it lasts.

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