Stock prices are giving investors a case of the jitters

12/31/1840 7:00 PM

06/03/2014 2:23 PM

Let’s jump into the wayback machine.

It’s October 2007.

The Dow just hit a high of 14,165; the S&P 500 index was at 1,565.

The market has been churning upward for years, so you can’t say those numbers are the result of a bubble in equities. The bubble that’s building is in housing and mortgage-backed bonds.

And that’s the bubble that will blow up in our faces and cause a financial crisis that ravages stocks over the next two years, sending investors fleeing in a panic and cutting the Dow and S&P in half from their October 2007 highs.

Yes, looking back, it’s hard to remember the damage was so terrible.

But let’s tweak the dials on the wayback machine and make the housing bubble and follow-on financial crisis disappear. Assume instead that the economy continued to chug along at a normal pace.

Without the financial crisis, where do you think the Dow and S&P would be now?

That’s a fantasy question worth asking amid the nervousness over whether the current bull market is getting wobbly legs.

The markets are again touching all-time highs. Not only in the United States but on stock exchanges around the world.

Investors seem to be just shrugging off recent rounds of lackluster economic statistics.

Last week came news that the GDP in the first quarter actually shrank 1 percent, the first decline in three years. Consumer confidence has slipped a bit recently. Retail sales for April were weaker than expected. Industrial production also fell. Job growth is increasing, but loads of people are dropping out of the labor force.

Company profits are under stress. In the first quarter, they were up just 2.1 percent compared with last year’s first quarter and dramatically below the 8.5 percent rise in the final quarter of 2013.

Year-over-year numbers still indicate the economy is growing modestly, and analysts expect a better second quarter and rest of the year. But that’s hardly reassuring to investors nervous about the current market heights.

Fear of future weakening has driven some investors into bonds, lowering already low open market interest rates. And that’s with the Fed cutting back its support of the bond market.

One traditional measure of whether stocks are overvalued is the forward-looking price-to-earnings ratio. It indicates how much investors are willing to pay for each dollar of expected earnings over the next year.

For the broad-based S&P 500, the ratio historically is around 14.7 times expected earnings. Currently the ratio is 15.3, which certainly doesn’t indicate that investors have been recklessly bidding up prices.

An admittedly quick seat-of-the-pants way I use to judge the market is simply to look at company profits. If profits are rising at a decent clip, stock prices will hang in there even in a choppy market. If profits are slowing but remain positive, as they are now, the market could drop, but probably not enough to worry about.

To take a really long-term view of stock prices, I occasionally turn to the wayback machine and ask where stock prices might be now compared with several years ago, assuming the market matched its usual historical trends in an economy growing at its usual pace.

Then I compare those estimated stock prices to what they are now given the current economy — in this case an economy recovering from the financial crisis.

So let’s assume a normal economy over the last seven years, with the market rising at its historical norm of 8 percent a year.

Using the 2007 highs as starting points, the Dow would now be at a whopping 24,000, while the S&P would be around 2,700. That would mark a 70 percent rise.

If an 8 percent annual return is too supercharged for you, assume a more modest 5 percent. At that rate, the Dow would be around 19,600, up 38 percent, and the S&P at 2,300, up 47 percent.

In contrast, the Dow closed Monday at 16,743.63. So in seven years, the Dow is up just 18 percent.

The S&P, despite closing Monday at 1,924.97 — it closed above 1,900 for the first time just last month — is up around 22 percent.

Given that, it appears that stock prices haven’t outrun the current economy, that they pretty much reflect an economy still recovering.

Of course, you should follow the standard advice to view all such prognosticating with a skeptic’s eye. You need to make your investing decisions based on your stage of life, and whether you might need some cash immediately. Remember to stay diversified.

And take into account your tolerance for risk, which is what ultimately makes you nervous.

As for being nervous about stock prices, here’s some investment advice: I’m ALWAYS nervous about the market.

To reach Keith Chrostowski, business editor of The Star, call 816-234-4466 or email chrostowski@kcstar.com. Twitter: @keithc3.

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