Major U.S. stock market indexes are starting to bear an uncanny resemblance to the Energizer bunny: They just keep going and going and going – going higher, that is. A morning rally pushed the Dow past 13,000 for the first time since May 2008 – and up almost 100 percent from its 12-year closing low of 6547 reached on March 9, 2009.
How long will the batteries last, however? Barron’s recently published a cover story, drawing on work done by Wharton professor Jeremy Siegel, suggesting that the Dow Jones Industrial Average is nearly certain to hit 15,000 sometime within the next two years, based on an analysis of market cycles. And there’s a 50 percent chance we’ll see Dow 17,000. Either would take the blue-chip market indicator into uncharted waters; the Dow’s all-time record close is 14,164.53 on October 9, 2007.
But while the bulls are certainly running down on Wall Street right now, that doesn’t mean that the stampede will continue. For every reason to be optimistic – the stubbornly high unemployment rate is finally falling; companies like Apple are posting impressive gains in profits – there is a sign that the recent gains may not be sustainable for long, much less serve as the foundation for the kind of mega-rally that would be required to propel the Dow toward 17,000.
Most importantly of all, despite all the positive earnings surprises of late, fourth-quarter profits posted only single-digit gains in aggregate (the specific numbers vary depending on which source you consult) compared to percentage increases in profitability in the mid-teens during the third quarter. Moreover, the outlook for corporate profits isn’t all that rosy. Rather than upgrading their outlook, more companies are cautioning their shareholders that the economic headwinds may dampen their ability to post big positive earnings surprises down the road. Sure, the uptick in employment levels is good news – more people with jobs means more paychecks that can be used to buy goods and services – but consumers’ moods could sour just as rapidly as they have improved of late.
The big cloud on the horizon is, of course, what is happening in Europe – and spiking gas prices could still darken the economic picture, too. Traditionally, in the aftermath of a recession, Europe has responded to an improving U.S. economy by shifting into growth mode as well. Clearly, the events on the Eurozone’s periphery mean that isn’t going to happen this time around – indeed, the opposite could be the case, with Europe’s woes spreading across the Atlantic like a particularly nasty virus.
Right now, investors in U.S. stocks are viewing the glass as being half-full – and in some cases ignoring or overlooking factors that might cause them to reassess their ebullience. The United States is in the early stages of what may turn out to be a very nasty confrontation with Iran. There’s no long-term bipartisan agreement on anything of substance in Washington (despite the temporary truce that enabled the extension of unemployment benefits); indeed, the fight over ongoing reforms of the financial sector appears likely to become a pitched battle between those who believe any regulation is by definition a curtailment of free markets and those who argue that the financial crisis of 2008 is merely a foretaste of what is to come if new rules aren’t introduced pronto. The list of potential causes for anxiety is long – and very familiar to anyone who has been trying to find a way to make money from stocks for the last three years or so.
It would be downright foolish to invest in large-cap stocks today on the expectation that the Dow is en route to 15,000 and perhaps even 17,000 and that we’re in the early stages of a bull market the likes of which we haven’t seen since the 1990s.
On the other hand, stock valuations remain well below levels recorded in 2007: The price/earnings ratio is below its 10-year, 20-year and 30-year averages today, in spite of the fact that interest rates are lower. (Low interest rates make the present value of future earnings higher.) As Aaron Gurwitz, chief investment officer at Barclays Wealth, points out in a letter to clients, an investor who abandons U.S. stocks simply because the rally has lasted a while isn’t behaving in a terribly rational manner.
What does all this add up to? Good news for options dealers, who are likely to see a big surge in activity in both puts and calls. Whenever investors get the jitters or lack conviction, options are the investment vehicle of choice. Someone who is already long can use them to hedge their holdings (whether individual stocks, baskets of securities or indexes), and an investor who is wary of volatility can use options strategies to put their big toes in the water. Given the sharp decline in stock market volatility to more normal levels, options are also a more accessible and affordable strategy than they have been for a while. Buying a call option on the S&P 500 is less costly and less risky than owning the large-cap index outright. And a great investment strategy is always all about making use of all your options…