Investment Education: Will this stock market rally continue? Some factors to consider.

May 6, 2014 Investment Education: Will this stock market rally continue? Some factors to consider.

Right now, we are in a “momentum market.” New investors, or those who gave up on the market years ago are pouring in and pushing rising stocks higher. This is something typically seen when the market is near a top, although that top is not necessarily immediate. But here are some reasons why the rally might be sustainable: stable energy costs and the second internet revolution. First, stable energy costs. From the 1970’s until a couple years ago, companies had to bake in assumptions of ever increasing energy prices and periodic, unpredictable energy shortages and price spikes. With that fear now subsided due to sharply increased domestic energy production, company focus, energy hedging costs, and capital expenditures can move away from energy efficiency. Similarly, management can be more comfortable with its long term planning, which implies a lower hurdle rate for new capital spending projects, implying more capital spending, with all the company and macro-economic benefits that follow. Second, we are now in the second internet revolution. The first internet revolution, late 1990s and early 2000s, saw significant improvements in operating efficiency. Example: steel companies reportedly cut their sales staffs and costs by 70-90%. In the second and current internet revolution, an ‘internet of industrial things’ is enabling reductions in manufacturing costs and improvements in work flow planning. You can see this with so many companies reporting increased profit margins despite minimal, if any, sales growth. A profit margin rebound is normal coming out of a recession as prior layoff costs and other write-downs come to an end or are reversed, and companies are likely operating with excess capacity. But in the 4th or 5th year of a recovery, this rising profit margin phenomena is not typical. I can’t predict how much longer these benefits will accrue, but for now, both are producing a rising tide that is lifting many ships. Is this as powerful as the 1995-2000 internet/Y2K rising tide? Not comparable. Y2K had a termination date. New computers had to be installed and working by 1-1-2000. There is no such deadline now. The second internet revolution may be more comparable to the industrial revolution we all learned about in high school: a break-thru technological shift with immediate impact in some sectors, but permanent benefits going forward.

So will stocks go up forever? Of course not. Bull markets often end due to unpredictable “black swan” events: 9/11 in 2001, and the housing/mortgage bond induced liquidity crisis in 2007-8. By definition, we cannot predict the next black swan. But valuation still counts for something. As we discuss in Chapter 18 of Why Stocks Go Up and Down, high valuations (P/E ratio, Enterprise Value/EBITDA, etc.) do not mean a stock cannot go higher. But it does mean that if a stock is “priced for perfection” and something goes wrong, the stock has lot more downside than upside. When stock valuations suggest an unfavorable reward/risk ratio, it might be best to take some profits.

Note that in Chapter 18, we do not attempt to give a precise valuation model. (We don’t have one.) But we do try to give readers many ways to look at price/earnings ratios and other valuation methods, so they come away with a better understanding and more confidence in their own conclusions about valuation. Readers can also see how valuation is applied in our case study of Abbott Labs in Chapter 19.