Is the Market Too Hot to Handle?

By Ron DeLegge, Editor of ETFguide.com

Bam! The U.S. stock market ended 2013 on a euphoric high.

The S&P 500 recorded its fifth consecutive yearly gain by rising 29.6%. The Dow Jones Industrials added 26.5%, and the Nasdaq Composite jumped 38.3%.

With such sizzling gains, are investors getting spoiled?

A basic understanding of history shows us that bull markets in stocks can vary greatly in both length of time and price return. The table below highlights the 20 cyclical bull markets since World War II, with a bull market defined as an extended period of above-average stock price increases, coupled with abbreviated declines.

For perspective, let’s compare the length of the current bull market with previous ones. Although the bull run from Mar. 31, 2009 to Apr. 30, 2011 lasted just 760 days, if we merge it with the Oct.31, 2011 to Dec. 31, 2013 bull market, the combined duration is 1,552 days.

That’s more than double the length of the median bull market since 1945, which has lasted just 700 days!
On the other hand, the duration of the current bull cycle is still shorter (1,541 days) compared to the 2,830 days from 1990-98 and the 1,826 days from 2002-07.

Although today’s bull market duration may not look statistically unusual, its heavy dependence on central bank generosity is definitively unlike previous eras. And that’s the biggest difference of now versus then. More importantly, how will the stock market behave in a post-QE world?

Arguments of equity valuations are a fruitless exercise. There is no light bulb in the stock market’s brain that suddenly triggers a rally because stocks are cheap. Likewise, that same light bulb in the stock market’s brain that suddenly triggers a selloff because stocks are expensive doesn’t exist.

History, for those of us who still bother with it, teaches us the stock market doesn’t necessarily need to be grossly overvalued before it can suffer a severe correction. Have we already forgotten what occurred in 2007?

The S&P 500’s Price to Earning's (P/E) ratio was just 19.42 in October 2007 compared to a frothy 29.41 in March 2000. By historical standards, the U.S. stock market in the fall of 2007 was a bargain compared to the stock market of 2000! But that still didn’t stop stocks from declining almost 50% over the next 18 months.

In retrospect, people that used historically cheap P/E ratios in 2007 as a reason to buy stocks were badly misguided.

Ultimately, stock market valuations do matter, but emotion and psychology (or what technicians call “market sentiment”) play key roles in moving stock prices, too. This will always be the case, as long as the stock market has human participants.

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The views expressed here are that of myself or the cited individual or firm and do not constitute a recommendation, solicitation, or offer by myself, D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.

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