Defying Gravity

The S&P 500 price index reached yet another round-numbered all-time high on Thursday, hitting 1700 during intraday trading—leaving many worried what goes up must go down. In our view though, this “fear of heights” mentality is unfounded. All-time highs—like any arbitrary price level—say nothing about future direction. Stocks don’t move on past price movement. They look ahead, toward future corporate profitability and positive fundamentals suggest this bull is poised to run for some time.

In a typical bull market, it’s not unusual for the market to hit scores of new highs. For example, the S&P 500 Price Index set 308 new closing highs during the 1990s bull market. Between the first and ultimate closing highs during the period, the index returned 314%.

Exhibit 1: S&P Price Index Since 1990

Source: Federal Reserve Bank of St. Louis, as of 7/26/2013.

Those first few all-time highs likely felt scary to investors with fresh memories of the 1990 bear market. But had investors sold off, they would have missed a massive upswing. Simply, laws of physics don’t apply to stocks—gravity and momentum don’t exist in markets. To say they do implies stocks move on what’s happened in the past—that past performance dictates future returns. But it’s not true. Past price movement and arbitrary index levels don’t correlate with future movement.

But that doesn’t mean investors can’t identify forward looking market trends! As ever, they merely have to look forward—namely, at the gap between investors’ expectations and reality, which is largely what determines market movement over time. When reality outpaces investor expectations, stocks typically rise. And this is exactly what we see today and looking forward—investor sentiment is still rather mixed about economic health despite myriad signs of healthy growth. Folks seem stuck between skepticism and optimism. They can see some strength in certain areas, but worries persist. For example, investors today appear to fret seemingly sluggish economic growth, weak Emerging Markets growth and seemingly less-than-stellar earnings for non-financial firms in Q2.

But the reality in these areas is better than most perceive. Headline Q1 GDP growth of 1.7% y/y might not be not gangbusters, but under the hood, the private sector continues to strengthen. Businesses are investing more, consumers are spending more, and total trade is on the rise—domestic and foreign demand are quite firm. Some Emerging Markets growth rates might be slowing, but these nations still contribute vastly to global trade. Headline Q2 earnings growth of 4.2% y/y might appear driven by strong Financials results (a result of the sector’s very easy y/y comparisons), but non-Financials firms aren’t uniformly weak. Sectors like Energy, Materials and Industrials are having a tough time—as we’d largely expect later in the cycle—but earnings and revenues are largely growing apace in less cyclical categories. Moreover, slower earnings growth is fairly normal in maturing bull markets. Looking ahead, what matters most is earnings are high and largely beating expectations—the gap between reality and sentiment persists.

These fundamentals—not index levels—are what contribute to market direction. All-time highs are just numbers. In terms of forward-looking significance, they’re rather meaningless. What matters more is sentiment largely remains mixed, providing ample space between reality and expectations—evidence, in our view, the bull market is far from over.