Like ducks in the desert

A steady current of surprise and unease has been running through the popular financial press and blogosphere during the long current bull run for US stocks. Many pundits seem confused and worried, like ducks in the desert, that something is seriously wrong. The S&P 500 is now up 100% since the bad old days two years ago. And the benchmark index is up 100 points this year alone, despite many gloomy forecasts, such as this one from January 2011 that called for major reversals that have not materialized.  Why are stocks doing so well?

There’s no magic to the US equity market’s sustained rally this year, and for two years running.  Many factors move the market day to day, but in the long run it’s the financial performance of listed companies that determine what stocks do.  The fundamentals – earnings, growth, margins – have been consistently positive in recent quarters. Clearly, many experts did not see this coming. And many investors, trusting what they saw on TV or read on the internet, have missed out on the big rise after bailing out during the big fall.

That the market could regain most or all that it lost during the financial crisis is not a complete surprise. It’s the timing and speed of the move that has left many on the outside looking in.

Why the profits?

Frankly, the consistent quality of fundamentals has been a surprise to me, too. But here are a few elements that help to explain what we’re seeing: free money, low taxes and cheap dollars.

Free, or almost free, money makes profitability a lot easier. Last August, IBM borrowed $1 billion for 3 years at 1 percent!  Johnson & Johnson raised $550 million for ten years via bonds paying less than 3 percent. With that kind of low cost leverage, it’s hard not to make a profit.

Next, look at corporate taxes.  GE got scorched by the New York Times, when the company paid no corporate taxes in 2010, on profits of $5 billion.  Amid all the screaming about our high corporate tax rate, corporations paid only $191 billion in taxes in 2010, about 9% of all Federal revenues.  Less tax means more profit.

And cheaper dollars are a simple way to get a cost advantage.  With the US dollar down 15 percent from last summer’s peak, that translates into a 15 percent price cut for the rest of the world buying US products.  No mystery there.

With these advantages, it’s no wonder earnings have soared. After the fact it’s all pretty simple to explain. After all, today’s announcements of record profits and record growth merely confirm what has already happened.

But predicting next year’s earnings is another story.

Stop predicting

Because we can’t know what will happen next year until it happens, we suggest a simple strategy: Relax, stop predicting, and index.

A buy-hold-rebalance indexing approach is a surefire way to participate in markets without introducing any timing mistakes based on hunch, rumor or the advice of pundits and gurus. When you dismiss the idea of trying to outsmart the market and accept market level returns, investing becomes far less emotional and stressful. Yes, it’s possible to buy in too high on occasion, but it’s the opportunity cost of completely missing a big run up like we’ve experienced the last two years returns that can be even more costly.

It’s worth revisiting a classic chart that shows the dwindling returns of an investor who misses the best market days during a ten year period through faulty timing:

Returns for 12.31.94 -12.31.04  Source: Factset Research Systems, AIM Distributors Inc.

There will always be “experts” who preach that the market is too high or too low, that it’s time to buy or sell, or that a certain stock is ready to go through the roof.  When they guess right they seem like geniuses. But just as often they end up looking like ducks in the desert, left high and dry by taking the wrong turn. With the potential cost of guessing wrong so high, I suggest a simpler approach – relax, stop predicting, and index.