Domestic equities confounded anyone worried about a possible repeat of August 2011 and reached year-to-date highs in mid-September. The Dow hit a level not seen since December 2007. The questions many are asking are: Why in the world are stocks going up? Doesn't the market realize we're facing an election year, an upcoming fiscal cliff, and unrest in the Middle East?
Retail investors seem confused by this year's strong stock market performance despite a shaky economy and weak labor market. The explanation can be summed up in one word: "productivity." Companies have become lean and adaptable in order to boost profits and compete globally. For example, in just the past four years, Harley Davidson has consolidated its production process from 41 buildings down to just one where robots do the heavy lifting now.
Improved technology and greater efficiency often result in less need for workers. It also means the need for new skill sets in the workforce. Many investors are waiting until the unemployment rate is back to normal and all their friends have jobs as a type of "all clear signal" in the markets. By then they will have missed the boat. As heartless as it sounds, profits drive stock prices, not employment.
There is an old saying that stocks climb a "wall of worry." In other words, by the time the average investor is feeling optimistic, most of the "run up" will be over. Retail investors feel best about buying when they should be selling and vice versa. This story repeats itself time and again, but investors rarely can see past their emotional biases. In fact, a recent Dalbar study, "Quantitative Analysis of Investor Behavior," shows the average investor underperformed every major asset class over the past 20 years.
So, how do investors capitalize right now?
The great thing about being an investor today is that it's not just stocks that offer solid opportunity. Foreign currencies, alternative strategies, foreign fixed income, MLPs and other asset classes all offer a much better deal than sitting on the sidelines. If you separate the data from the emotion, the data looks pretty good.
Unemployment has fallen to 7.8 percent from a high of over 10 percent in 2009. Housing starts have risen to 754,000 from a low of 478,000 in April 2009 and new homes sold totaled 372,000 in July up from a low of 273,000 in February 2011. Additionally, corporate borrowing rates are at obscenely low levels at a time when profitably and productivity are at all-time highs. The average S&P 500 company has a Return on Equity (ROE) of over 16 percent. That means investors earn 16 percent on their net assets (assets - liabilities). Great multinational companies are lean and mean and still on sale!
Stocks have historically traded at about 15 times earnings. Today, they are trading at 13-14 times next year's earnings. Given today's low interest rates, stocks should be trading at a premium; yet they are still trading at a discount, indicating room for growth. Developed international stocks are valued much lower than their historical average, and the fast growing emerging markets are trading at their lowest valuations in over a decade. If you invest based on fundamentals (instead of emotion), the only logical move is to buy stocks and similar assets here, and reduce positions in bonds and cash (assuming that we are talking about cash you won't need over the next couple of years).
Investors should never try to time markets. Their best bet is a well-diversified portfolio that overweight's the asset classes which are on sale and minimizes exposure to those that are valued above their long-term historical averages. But don't go too far overweight, or it could rock your boat! Never take too large of a position in any one investment. Admittedly, this caution might prevent you from making a killing on any one large bet, but it also prevents significant harm from an unforeseen event. In the end, this approach should enable you to to capture most of the market's upside while avoiding catastrophic downturns.