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New Highs, New Crisis?

What Will End This Rally?

Written by Briton Ryle
Posted March 6, 2013

And there you have it: a new all-time high for the Dow Industrials Average.

The last time the Dow was this high, gas prices were $2.75 a gallon. Only 6.7 million people were unemployed, compared to 13.2 million today. 10-Year Treasuries were yielding 4.64%, versus 1.89% today. And total U.S. debt was half what it is today, as was the number of Americans on Food Stamps.

Things sure seem worse today than they were in October 2007 (well, except for the fact that the housing market was about to implode and take the entire global economy along with it).

It is ironic that investors were a lot more enthusiastic about the stock market in 2007 than they are today. And it wasn't just investors. Consumer confidence was 99.5 right before the collapse. Today consumer confidence is just 69.6.

Of course, we knew this day was coming. The signs have been there for months, ever since the last-minute deal to avoid the tax impact of the fiscal cliff.

So the question is: What happens next?

Will stocks continue higher... or is it time to sell?

Stock Market Highs: A Retrospective

The 1990s was basically one solid decade of new highs for the Dow Industrials: Dow 3,000 fell in September 1991; 4,000 fell in March of 1995; by the end of 1995, the Dow was above 5,000.

By 2000, traders on the floor of the New York Stock Exchange (NYSE) were donning their “Dow 10K” hats. I remember that like it was yesterday.

The only blip on the radar for the decade was the monetary crisis that started in Malaysia and swept through the Asian Tigers, then moved to Latin America. That crisis, like most crises, was a buying opportunity.

A lot of investors like to remember the Internet/tech bubble of 1999-2000 as a time when investors went completely bonkers on stock valuations. It's tough to imagine Cisco trading with a P/E of 70. But let's not forget the Dow Industrials was down “just” 17% when terrorists flew those planes into the Twin Towers.

A year later, the Dow was 34% off its tech bubble highs. We'll never know what might have been if 2,977 Americans hadn't been murdered on 9/11. The world changed on that day, and the consequences (oil prices, wars, defense spending) still weigh on the U.S. economy.

On October 19, 2006, the Dow Industrials broke above 12,000 for the first time. It would add 2,000 more points over the next year. We all know what happened next.

The financial media is already issuing its warnings that new highs for the Dow usually end in some kind of calamity. But that's not exactly true. A true top for stock prices could be a year in the making, like in 2006-2007... or we could be looking at a period like the 1990s — where the U.S. economy slowly grinded its way out of a deep recession — that supported several new highs for stock prices.

Personally, I think the current environment looks a lot more like the early 1990s: Pessimism is high. Washington is a mess. Tax codes are impeding growth. It's hard to imagine better times ahead...

New Highs, New Crisis?

I understand many investors have a hard time connecting the dots between the economy and stock prices.

For an economy to be 70% dependent on the consumer, there are reasons to worry: 13 million of those consumers don't have a job. The ones that do just lost some of their spending power after the payroll tax cut was reversed. Wages are stagnant. And we're all paying more at the pump.

Consumer spending grew just 0.2% in February. Clearly, this is exactly why the U.S. is stuck at 1.8% growth.

With growth that slow, it wouldn't take much to push GDP back to the flatline. (But the converse is also true: It wouldn't take much to push growth to more respectable levels.)

The #1 Cause for Concern is the Fed. Once Bernanke and his minions decide to stop pushing $85 billion into the economy every month, stocks will sell off — regardless of the fundamentals.

In fact, all the Fed has to do is sound like it's maybe going to consider ending QE3, and stocks will drop. In that sense, the stock market rally is living on borrowed time, literally.

Nobody knows how the Fed will unwind its $3 trillion balance sheet. It's usually safe to assume that the Fed will, at some point, start selling its mortgage holdings. But the fact is the Fed doesn't have to sell anything.

Like it's done with short-term Treasuries, it can simply keep accepting payments until the notes expire. The Fed can get its money back without disrupting anything. Frankly, I'm surprised no one seems to have thought of this before.

How I Learned to Stop Worrying

I co-manage The Wealth Advisory newsletter along with Brian Hicks. We've had a phenomenal run since repositioning this service to focus on income and dividend investments.

The portfolio is up 24% since the start of 2013.

Yeah, that's an impressive performance. And I'll be honest; I don't want any of our 10,000+ readers to lose any money because we missed the early warning signs of a crisis.

Therefore, I closely monitor valuation levels for stocks. Because if there's one thing that's consistent with stock market crashes, it's stock valuations.

When investors are feeling really good about earnings growth — and economic growth — they tend to be comfortable with higher valuations, like P/E ratios.

It's a safe bet that nobody is optimistic about earnings growth or economic growth. All the pessimists out there say weak consumer spending simply cannot support corporate revenue and profit growth, and that earnings estimates and P/Es are overstated.

But for the life of me, I can't figure out which earnings estimates and P/Es they're talking about. The forward P/E for the S&P 500 (based one the next 12 months of earnings expectations) is 13.68. For the Dow Industrials, the forward P/E is even lower at 12.5

You can't tell me the forward P/E of 12 for Target (NYSE: TGT) is expensive; same goes for Wal-Mart and its 12.6 forward P/E. Cisco and Intel both have a forward P/E of 10! And at $200 a share, IBM (NYSE: IBM) has a forward P/E of 11.

We may get a correction. Those happen from time to time.

But a full-on crash or crisis seems unlikely when stocks are not expensive...

So, my Wealth Advisory readers will continue to benefit from both strong dividend payments and steady stock price appreciation.

If you'd like more details on The Wealth Advisory, you'll find them here.

Profitably yours,

Until next time,

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Briton Ryle

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An 18-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.


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