Can the Market Keep Climbing?

Sure it can.

But are we near the top of a mountain, about to go over the other side — or merely at the first base camp above the foothills?

And why a mountain? Why any ultimate peak? Why can’t the market just keep growing — with dips along the way — more or less forever? (Answer: It can. But, oh, those dips.)

You will notice these questions were not sent in by one of you. Your questions are generally a lot more succinct and your metaphors, more engaging. Still, aren’t these questions we all wonder about every time the Dow adds another grand?

(One thing to say right off the bat: 1000 points on the Dow ain’t what it used to be. Many of us grew up wondering if the Dow would ever reach 1000. When it finally did, adding another 1000 was a 100% gain. Today, an extra 1000 is about 14%. So one might now expect the Dow to rise 1000 points every couple of years, just in the normal course of things.)

Now, what I’m about to tell you is so basic we forget to think about it . . . or tell our kids. In case no one told you, or you’re dialing in from Albania, where there were no investors around for several decades to clue you in — read on.

Over the long run, two primary factors determine a stock’s price: its expected EARNINGS per share and the MULTIPLE people are willing pay for those earnings.

If people expect Ford to make an after-tax profit of $1 billion next year, and Ford is divided into 100 million shares, its expected earnings are $10 per share.

Now, what would you pay me for a share of stock expected to earn $10 a year?

“I’ll give you twenty bucks,” I hear one of you say.

“No, way, Cyberdude!” I say.

“Way,” you say. “For one thing, I won’t actually get that $10, the way I would from, say, a savings account. A bird in the hand is worth two in the shrub.”

“Piffle,” I say. “You do get part of it in cash, as a dividend . . . and you should be grateful you don’t get the rest — because that means you don’t have to pay tax on it! It gets reinvested for you by Ford management, very possibly better than you could reinvest it yourself.”

“Well, OK,” you retreat, “I’ll give you $50 a share.”

“Cyberdude, Cyberdude — you really are from Albania. Right now there are people paying nearly $150 to get $10 a year in earnings from long-term Treasury bonds. You expect me to part with $10 a year for just $50?” (A Treasury that yields 6.7% pays out $10 a year for every $150 invested.)

“Jzmlec!” you respond, reverting briefly to your native tongue. “You want $150? That is a multiple of 15 times the earnings! You want me to wait 15 years at $10 a year to get my money back? In Albania, we all went into a deal that promised to double our money every year!”

“Don’t give me ‘jzmlec,’ Genc.” (I actually hope to meet an Albanian civil rights activist named Genc in a couple of weeks. I expect he knows nothing of high finance.) “In the first place, you all lost 100% in that deal. We Americans are much smarter. Even those of us who bought Spyglass at 120 only lost 90% (symbol: SPYG). I personally lost 99% of my money in Kenetech, the highly-credentialed windmill company (symbol: KWND), but that’s still not 100% — and I got to ride it for several years.” (Some of my holdings are better viewed as amusement rides than investments — the longer the ride lasts, the more value I’ve gotten for my money.) “But I digress. The point is, Genc, I want more than $150.”

“Khlyep! Nyepryecz! That is riDICoolous. You think Ford as safe as U.S. Treasury? With Treasury, $10 guaranteed. For your shaky $10, I pay tops $95. Last offer. Take leave.”

“Genc, Genc, Genc. You totally miss the point. The Treasury bond will pay $10 for every $150 you invest. But just as the $10 is guaranteed not to go down, so, too, is it guaranteed not to go up. With Ford stock, you’ve got thousands of talented people working to improve profits. And if that weren’t enough, you’ve got inflation. Even at 2% inflation, car prices and car profits are likely to rise a little over time. So that $10 could well be $15 after a few years. How about $200?”

“Two hundred? Pfft!”

And around and around we — and thousands of others — go, debating the relative risks and rewards of various stocks, and of the stock market in general. According to the stock market, the ultimate arbiter of all such arguments, I would be crazy to expect Genc to pay me $200 for $10 worth of Ford earnings (just as he would be crazy to expect me to accept $20 or $50). Auto companies like Ford, being mature, cyclical, and faced with lots of competition, don’t sell at anything like 20 times earnings (unless those earnings have hit a trough in the cycle).

So that’s stocks. What will they earn; what multiple will those earnings command.

For the stock market as a whole, it’s the same thing. What will be the overall level of corporate profits; what multiple will investors assign those profits.

If U.S. companies as a whole are able to grow their earnings per share at 6% a year, on average, then U.S. stock prices should rise at 6% a year, if the multiple stays unchanged. For the Dow, that would mean adding about 400 points this year and reaching 10,000 in under six years. Dow 10000.

What’s been happening in the last few extraordinary, breathtaking years is that profits have been growing a lot faster than 6%, while at the same time multiples have been expanding, magnifying the good results further still. If profits double, the stock market quadruples if, at the same time, the multiple at which it sells expands from, say, 11 to 22.

In the Seventies, multiples were much, much lower because interest rates were high (why pay $220 for $10 in earnings when, with U.S. Treasury bonds yielding 15%, you need pay only $70 to get the same $10?) . . . and because people had forgotten how rewarding stocks could be. Today it’s just the opposite. Interest rates are low, and people have forgotten how risky stocks can be. And there are also the people piling into stocks, bidding up their prices, simply because “they have to” in order to reach their hoped-for retirement goals. The computer says they need to grow their money at 15% or 18% a year to reach their goals, so what other chance do they have? (Unfortunately, the stock market doesn’t care about your need, any more than the lottery does. Indeed, when it comes to investing, it’s usually the least needy who do best.)

The simple fact is that corporate profits very possibly will continue to rise more or less “forever.” There will be bad patches along the way — maybe even soon. Something awful or even cataclysmic could even happen. But it’s not unreasonable to think that our population, economy, technology, productivity and profits — just about everything, that is — will continue to grow. If the U.S. economy grows at 2.5% plus another 2.5% in inflation, that would suggest nominal growth of 5%. (Profits can grow faster than sales if profit margins rise — but that can’t go on forever. Math keeps them from rising above 100%. Taxes, labor, and competition keep them in far tighter check.)

But what of the MULTIPLE? Can that, too, continue to expand more or less forever? Emphatically: no. Just as interest rates can’t drop below zero, so is there is a limit — fuzzier, to be sure — to how high the stock-market multiple can sustainably go. It’s not reasonable to think that there are enough Albanians in the world to bid prices up to lunatic levels (you see how hard-nosed Genc has already become) . . . or, if there are, to keep them at such levels for long.

Most observers agree that the fun with the MULTIPLE is largely over. If you had the foresight, luck or resources to ride the great market multiple expansion that began around 1982, when inflation and interest rates started their long descent — congratulations. Long-term interest rates may yet have a ways further to fall. (From 1880 to 1965, there was never such a thing in America as a home mortgage at more than 6%. From 1925 to 1965, top-grade corporate bonds routinely yielded under 5%.) But the market multiple is at the high end of its range.

That means it’s likely to stay about where it is (very roughly speaking) — in which case earnings increases of 5% a year would mean stock prices rising at 5% a year. Or else it will fall — in which case earnings increases of 5% could mean stagnant or even falling stock prices for a while. And if you ever got falling earnings and falling multiples — the opposite of what we’ve had the last 15 years — watch out. It would not be pretty.

Of course, it’s all a great deal more complicated than this, which is why, fundamentally, I don’t have a clue. To the extent U.S. companies invest globally and reap vast profits from their operations overseas, the U.S. economy could grow slowly while those companies’ profits grow faster. (Just because a company is U.S.-based doesn’t mean all its profits come from sales that are included in the U.S. Gross Domestic Product. If they make stuff here and sell it abroad, yes. But if they own factories that make it there, no. Or at least I think that’s the way it works.) And to the extent companies use their profits not to pay dividends (the old-fashioned way to reward shareholders) but to repurchase their own shares (the new, tax-savvy way), earnings per share will grow faster than profits — because the number of shares shrinks.

And so on.

As is evident to any of you who are economists, I barely made it through Ec 1.

Still, I do draw these conclusions:

First, the market MULTIPLE is not likely to widen much from here — at least not justifiably (irrational exuberance is always a possibility). It could shrink a lot if fear or inflation ever returned. If it stays more or less where it is, and corporate profits rise more or less in line with the economy, the stock market will continue to climb . . . and the gains, even if modest in percentage terms, would seem large to us old-timers — 500 points on the Dow seems like a big deal.

Second, irrational exuberance is a possibility. Crowds have a way of going to extremes. People have seen how incredibly well stocks have done, and how whenever they do dip back toward a 10% correction, they quickly rebound with a vengeance. What’s the risk? In addition, you have the demographics of us baby boomers, finally saving for retirement, and shifting our money from “safer” investments into stocks (as I and so many others have long counseled). So there’s powerful momentum toward buying, and that drives prices and multiples up, too.

But these things can get out of hand and end very badly (witness: Japan). Or they can be moderated by a watchful force such as The Fed, which can serve as a sort of “governor” on the speed of the economy, so it slows down but doesn’t run completely off the rails. (Did you ever have model trains? Isn’t there an electrical device called a “governor”? Not for nothing is the Fed run by a Board of Governors.) Either way, stock prices will not rise at “above average” rates forever — of that I’m sure.

Which is why even someone like me, who’s spent twenty years trying to persuade people to put their really long-term money into stocks, “because over the long-run stocks always outperform ‘safer’ investments,” gets a little nervous when everyone seems to have come to accept that, and all the risk seems to have gone out of the stock market.

I’m going to get a real tongue-lashing from my friends who say — rightly! — “you can’t time the market.” But I nonetheless suggest that if you have all your retirement money in U.S. stocks, and you can make some changes without incurring taxes, I would consider doing so. A chunk of my own Keogh plan is in things like REITs (which are stocks, but essentially high-yielding real estate investments) and bonds (like the bonds of South Africa’s giant electric utility, ESCOM). After all, almost as well known as the tried and true advice about not timing the market is the advice about not putting all your eggs in one basket. And U.S. stocks — while magnificent and likely to do very well over the long run — are just one basket.

Next Week: The Star Arrives