Stocks at Multiyear Highs? Don't Be Shocked

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The Dow Jones (INDEX: ^DJI) is at its highest level in almost five years. The S&P 500 (INDEX: ^GSPC) isn't far behind. Add in dividends, and both are at all-time highs.

To Businessweek, this is crazy. It wrote yesterday:

Really, what business does the stock market have setting multiyear highs right now? The U.S. economy grew at an anemic 1.7 percent in the second quarter. It's creating 139,000 jobs a month on average this year; that is only a fraction of the monthly hires needed to bring the unemployment rate back to pre-crisis levels by 2015. The uncertainty of a close presidential election looms, and no one knows whether Congress and the president will reach an agreement to avert the so-called fiscal cliff -- the spending cuts and tax hikes that could stall the economy next year.

The magazine quotes one analyst as saying, "This is about the strangest market environment I've ever seen."


I don't buy it. Stocks at multiyear highs make a lot of sense, actually.

First, it's just as easy to say, "Wow, stocks haven't gone anywhere in five years," as it is to say, "Wow, stocks are the highest they've been in five years." Rallies are a matter of perspective.

But what drives the market over the long haul is earnings. And you know what? Businesses are earning a fortune. S&P 500 earnings are at an all-time high. Why shouldn't the index be?

Source: Standard & Poor's. *Most recent four quarters.

It's been hard for some to accept that despite nagging unemployment, dismal economic growth, and unspeakable partisan brawls in Washington, corporate profits have gone straight up for four years. But that's exactly what has happened. If you had tuned out all news except corporate earnings over the last four years, you'd think everything was going swell. There's a huge disconnect between middle-class America and corporate profitability these days (probably not coincidental).

And don't forget: About half of S&P 500 revenue comes from outside the United States. Some of that means exposure to the misery of Europe. But there's a lot of exposure to regions like China and Brazil, both far larger than they were a few years ago. Bob Doll, a former market strategist at BlackRock, estimates that 70% of S&P 500 earnings growth over the next five years will come from outside the U.S. No longer can you simply look at the U.S. economy and tie it back to the U.S. stock market. The globe is turning into one big (mostly) happy economy.

Then there are valuations. Excluding the crash of 2009, the S&P 500 is near the lowest P/E ratio in two decades:

Source: S&P Capital IQ.

Another way to look at valuations -- Robert Shiller's CAPE ratio, which averages together a decade's worth of profits -- shows the S&P at about 21 times earnings. Since the index was created in the 1950s, the average is 19 times earnings. Since 1980, it's 21 times earnings. So we're either very close or right on historic averages. Nothing too surprising.

What else has changed since the market was last at these levels in 2007?

  • GDP in 2007 was $14.2 trillion. Today, it's $15.6 trillion.
  • Consumer spending in 2007 was $9.8 trillion. Today, it's $11.1 trillion.
  • Dispsable personal income in 2007 was $10.4 trillion. Today, it's $11.9 trillion.
  • Total debt to GDP back then was 385%. Today, it's 352%.

Sure, there are risks. The looming fiscal cliff could throw us right back into recession. No one knows what might happen with Europe. The longer millions of Americans remain out of work, the harder it will be for them to return to work. There will be more recessions, more bear markets, and more plunges. They happen.

But no one should be shocked that stocks are rising. As a likely hangover effect of the dismal returns of the last 12 years, there seems to be a feeling that all market rallies are a sign of irrationality and obliviousness. I don't think that's right. The global economy and corporate earnings are grinding higher. As long as that's the case, so will stocks.

The article Stocks at Multiyear Highs? Don't Be Shocked originally appeared on Fool.com.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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