How Much Farther Can It Go?

As I write, the Dow Jones Industrial Average has closed at over 14,397, a 120% increase since its bottom of 6,547 at the market’s nadir exactly four years ago on March 9, 2009. Countless articles are being written on the subject of the sustainability of the rally, and I’ve had a number of clients ask me some variation of, “How much farther can it go?”  While they – and you – already know the answer to that question (“I don’t know.”), I’d like to take the market’s historic high as an opportunity to convey two equally important points.

First, the market has to hit 14,000 before it can hit 15,000, and so on.  At the end of the day, it’s just a number.  Mike Booker tells the story of his start in the business in the early-1980s when the Dow hit 1,000.  Clients at that time wondered if the market could go much higher.  Of course, it went on to hit 2,000 during 1987 and then on to nearly 3,000 in 1990.  The rest is history.  Over the long-run, markets are driven by the earnings of corporations, and as we’ve written about in the past, corporate earnings have never been stronger.  On top of that, their prospects have never looked better.  Companies are awash in cash, which they are using to increase dividends, buy back their own stock, acquire competitors and invest in capital improvements.  The energy boom is in its infancy, and U.S. energy independence is now a near-term possibility.  Cheap natural gas and new technologies like 3-D printing are already leading to a renaissance in U.S. manufacturing.  All of these factors, and many more, provide support for continued growth in stock prices over the long-run.

The second and equally important point is that, over the short-run, markets are driven by exogenous events and the emotions of fear and greed.  What the heck do I mean by “exogenous events”?  The nuclear meltdown in Japan in March 2011 is a good example.  The build-up to the Fiscal Cliff last December is another.  These are short-term factors outside of corporate earnings that create uncertainty and the fear that comes along with it.  While these events are unique and unpredictable, one thing is absolutely certain.  There will be exogenous events almost every year!  Something will happen which no one could have predicted that will cause the market to react, sometimes positively, but more often negatively.  That leads me to the following prediction: the market will likely experience a correction sometime this year.  Note that this prediction isn’t particularly bold.  It is the equivalent of the weatherman telling us it will rain sometime this spring.  Why?  Because the market has experienced an intrayear decline every year since 1980.  Over the last 33 years, the average intrayear decline was…wait for it…14.7%!  (I first wrote about this in my Q3 2011 newsletter column.)  To be perfectly clear, I’m not predicting that the market will go down 14.7% this year.  I’m simply saying that we should prepare ourselves for the market to experience a decline at some point because market history tells us this happens every year.

Now here’s the rub.  We have no way of predicting when these downturns will occur, or how long they’ll last, or how deep they’ll go.  The solution, then, is to stay invested throughout the declines.  We can afford to do this because none of our clients are invested solely in stocks.  Our diversified approach, which incorporates bonds, hard assets and alternative strategies, allows us to endure these corrections with less downside participation.  At the same time, we maintain the exposure to stocks so we are positioned to experience that long-term growth I talked about above.

For today, we’ll dance while the band is playing.  But we would be remiss not to prepare ourselves for a pullback sometime in the future, whether it starts next week or next quarter or beyond.  Know that your portfolio is prepared for these temporary downturns.  And as this historic post-2008 recovery illustrates, even the biggest, baddest downturn since the Great Depression was, indeed, temporary.