The Seven-Year Switch
The year 2004 has served as a useful, if imperfect, touchstone for investors. Some parallels are eerie, some mere coincidence. What it means for 2011.
When it comes to conjuring what the future will hold through 2011, leave it to an old history major to first recount some relevant themes of the recent past.
With the stock market tickling new highs as an oft-anxious, largely range-bound year sets, we still can say, "This year, the stock market's gains have been capped by sluggish job growth, limited wage gains and concerns about a slowing economy.
"On the upside, however, stocks were bolstered by corporate-earnings growth…[well] above what analysts had forecast a year ago. Due to the one-two punch of low interest rates and heavy government spending, money flowed freely this year. As always, much of it found its way into the riskiest investments, some of which posted the year's best returns."
This was true of the year now ending -- just as it was true in December 2004, when this recap appeared in Barron's market-outlook cover article ("A Bullish Toast to 2005," Dec. 13, 2004).
The year 2004 has served as a useful, if imperfect, touchstone here for at least a year. Some parallels are eerie, some are mere diverting coincidence. As 2004 opened, the Standard & Poor's 500 index had rallied ferociously off a March bear-market low and sat at 1112; this year it began at 1115, having surged even further from its March 2009 bear-market trough.
In '04, it knocked around a narrow path until a late-year rally carried it above 1200 to 1211. This year the ride was similar, if more dramatic, rallying into April and then dropping quickly by 17%, before the late-year rally carried it back above 1200, to a current 1243.
In both years, the consensus entering the year was that Treasury yields should rise and the market would remain volatile. In both years, the 10-year Treasury yield, while jumpy, hardly budged from start to finish, and market volatility plummeted all year, reflecting the numbing effects of heavy liquidity.
Then, as now, the market was up respectably, yet finished at a valuation lower than where it started, with corporate earnings advancing far more than share prices did, even as profit growth was about to decelerate sharply.
Yes, of course, historical analogies go only so far. Hold the e-mails inveighing that in '04, Humpty Dumpty was still on the wall, the credit bubble was still being inflated, that we are now in an economy detached from precedent.
There's no denying the economic hole this time was much deeper, the fabric of the financial markets was torn far more violently, and the observable risks to the global economy today are certainly more daunting.
Yet markets have rhythms tied to the interplay of psychology and the business cycle. And while they are only a rough guide for what to expect, what they aren't is irrelevant. Investors forget that it's better to have the problems exposed and absorbed than to be unaware they're there, fuses burning.
The stock market capitalizes not the absolute level of strength in the domestic economy, nor the mood of the median household, but rather a private profit stream of mostly large, substantially global companies. With the S&P 500 at 1200 six years ago, analysts were looking for $72 in S&P earnings the next year; now, at just above 1200, the consensus is near $95. That still isn't outright cheap, given the contingency of such forecasts and the world's instability, but it certainly isn't a challenge to further upside should the world decline its plentiful invitations to end.
And the psychology on Wall Street now is pretty close to where it was a few years ago―mostly bullish, with a growing collective belief that things have turned for the better, after months of mass frustration over the unsatisfying pace of economic recovery. This is probably a short-term challenge for further market progress.
As this week's cover story sets out, professional market handicappers are collectively quite optimistic about the coming year in stocks, looking on average for handy double-digit gains. In '04, this club was bullish, but not expecting much more than mid-single-digit percentage gains.
The weekly American Association of Individual Investors poll has registered above-average (and lately borderline extreme) levels of bullish opinion for 15 straight weeks. The last streak of such duration was -- guess when -- from August to December 2004.
Without prolonging the suspense, the first part of 2005 was flat to down into April, and then recovered, suffered the scripted autumn pullback before surging into year end for a modest annual gain, giving way to what would be a quite strong 2006.
This would fit with history, too, if something like this course played out next year. Oppenheimer strategist Brian Belski, noting the growing bullishness among Wall Street strategists, points out that a third year of double-digit gains -- implicit in the consensus forecast -- would be an anomaly. Since World War II, there have been 10 back-to-back double-digit advances. Only twice (1951 and 1994) did the streak run to a third year, and the average return in the third year was 1.7%.
BACK TO TODAY: After closing eyes and ears to any signs of possible economic improvement or policy progress for the middle part of this year, as Europe's debt disease and domestic double-dip paranoia were paramount in investors' minds since the election, the standard bullish talking points are on the lips of most market players.
The Fed is pumping money in, which is good if the economy needs it and better (for markets) if it doesn't. Profits are poised to keep growing, the economy has some traction, lower taxes are a boon. And if one more pundit "informs" us that the year after a midterm election is "always" positive, and is the strongest year in a presidential cycle, it might be time for self-defined contrarians to stage a ceremonial burning of the Stock Trader's Almanac in front of the New York Stock Exchange.
This cozy consensus is more a short-term tactical risk to the market than a run-for-help signal, and it ought to be upset by the headlines or a sudden selloff before too long. This would perhaps puncture some prevailing optimism and set the next investment theme on firmer footing.
Against this near-term bullishness remains a heavy and only slowly thawing aversion to risk among the public, and an abiding demand for catastrophic financial-risk insurance. This, along with the fact that the market sits at a level first reached almost 12 years ago, continues to argue that those with a five-year-plus time horizon enjoy tailwinds to their returns.
We are at the point in the market cycle where massive profit recoveries and the reversal of dramatic oversold conditions following a terrible bear market give way to variations on the "greater fool" theory of owning something because someone else is apt to come along and pay more for it.
And so the bullish voices are insisting that nervous stock-avoiders will react to a firm market, tax goodies and signs of economic momentum by slowly reallocating toward stocks. Could be, though this never seems the dramatic swing factor in equity prices that it's made out to be. Consider that the market is up 83% from its March '09 low, and most of the time Main Street was pulling money out.
But one form of "greater fool" investing that appears far more likely to tilt 2011 further to the upside than the baseline case for moderate gains, after a pullback or sideways stretch, is a burgeoning revival of financial engineering: leveraged buyouts, debt-financed buybacks, aggressive growth-seeking mergers and the like, most all equity-friendly.
This would also represent a re-run of the mid-2000s (and the mid-'90s, and the mid-'80s, for that matter). One would hope this action would be carried out with some important lessons learned and a new-found sobriety. Hope for it, but don't bet that way.
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