By: Jeff Sommer
January 13, 2014
After two improbable, gravity-defying years, the streak is over.
What streak am I talking about, exactly? It’s this: On Dec. 31, 2011, the Standard & Poor’s 500-stock index closed at 1,257.60. On the first trading day of 2012, it rose at the opening bell and never dropped below that level all year long. And on Dec. 31, 2012, it closed at 1,426.19 and, again, for all of 2013, never fell into negative territory.
In other words, the market remained in the black for two consecutive years, a feat it accomplished just once before in modern history, in 1975 and 1976. But you’re forgiven if you didn’t notice.
The recent streak wasn’t visible unless you were looking for it. It was a string of no-big-deal, Steady Eddie achievements — much like the ironman streaks of Lou Gehrig and Cal Ripken Jr., who showed up at the baseball park every day for so many years that people finally realized they were staring at feats of monumental proportions.
This streak wasn’t featured on television, as far as I know, and no contests or T-shirts have celebrated it. But it seems worth noting, not just because it was quirky but because it symbolizes the lighter-than-air quality of the stock market over the last two years. Now, with stock valuations beginning to be stretched and the Federal Reserve starting to taper its loose monetary policy, an enchanted time for stock investors may be coming to an end.
If you’re a regular reader of this column, you may actually recall the streak. It started unremarkably: Stocks rose and the market closed higher at the end of the first week of 2012 than it stood at the beginning. Nothing startling about that. But as the year went on, the S.& P. 500 never dropped below its opening level for the year, not even once, and that was unusual. That had happened only eight times before.
I became aware of the phenomenon late in 2012, when Paul Hickey, co-founder of the Bespoke Investment Group, brought it to my attention. It seemed especially surprising at the time because 2012 never made headlines as a great year for stocks.
When the streak continued in 2013, I wrote about it twice. Week after week, the market remained in positive territory for a second consecutive calendar year. Even though the streak itself never became a fixture of the popular imagination, public opinion about the market shifted as time passed: Investors began to move money into stock mutual funds and exchange-traded funds, and just about everybody knew that a bull market was underway.
The streak ended when trading began for this year on Thursday, Jan. 2. The market fell that day, and dropped further the next day, closing down for the week. (The first positive day for stocks was this past Tuesday, and the market is now down slightly for the very young year.)
But what a two-year run it was. With a chain of moderately positive weeks, and no truly big breakout sessions, the market mounted a stealth rally in 2012, up 13.4 percent for the year. It picked up steam in 2013, gaining 29.6 percent. (That reversed the earlier streak’s pattern: up 31.6 percent in 1975 but only 19.2 percent in 1976.)
Those are the numbers. But what are the implications?
The streak itself was an anomaly, with no particular statistical significance in itself. But markets typically don’t rise this steadily or rapidly. A rally of these dimensions has consequences.
For one thing, the accelerating double-digit increases in stock market prices outstripped the rise in corporate earnings over the same period. Stocks were relatively cheap at the beginning of the streak. They’re much more expensive now.
Mr. Hickey and Justin Walters, the other Bespoke co-founder, put it this way in a report on the investment outlook: “2013 really marked the year where investors recognized that equities were attractively valued.” But that realization changed the market: Investors bid up prices, and by year-end, valuations had shifted sharply.
The Bespoke analysts focused on the price-to-earnings ratio, a commonly used valuation measure. When the ratio is high, which occurs when investors pay a higher price for corporate earnings, stocks are relatively expensive. Using trailing earnings — those accrued over the preceding 12 months — they noted that the ratio soared 23 percent, from 14.64 at the beginning of the year to 18.01 by the end. That valuation shift accounted for most of the market’s gains for the year.
What’s more, they said, the P/E’s historical average was only 15.3. In short, at the beginning of the year, the market was cheaper than average. By year-end, they said, “technically speaking,” the market was overvalued.
That implies that stocks are no longer a bargain — and that investors may be taking on greater risk when buying shares. It implies less certainty and greater volatility. But it doesn’t necessarily mean that the market’s upward trend will reverse soon. History shows that markets often rise for a while when they are overvalued.
In an interview, Mr. Hickey said the market wasn’t likely to be as steady as it was during the streak, but he expected it to rise further: “In the later stages of bull markets, valuations generally expand and that’s what’s happened here,” he said. “Prices today aren’t nearly as attractive as they were, but typically bulls don’t end with the market at an average valuation. Bull markets typically overshoot.”
Interest rates are another factor that is no longer quite so beneficial for stocks. Low rates helped to drive the rally, and rates are still low on a historical scale — but not as low as a year or two ago.
In many investment models, stocks are still more attractive than bonds. But that’s not a very powerful claim, because the bond market just had its worst year in decades. And the Fed, soon to be led by Janet Yellen, is starting to throttle back its accommodative interest rate policy. Investors need to monitor rates closely this year.
Now that the streak is over, it’s not a terrible environment for the stock market, but conditions have changed and risk may be rising. We’re entering a new world.
Gold Goliath is not your typical gold dealer.