It seems there are always a lot of misconceptions about stock market performance, its connection with the economy and the general health of the markets. Just last week I heard a couple people mention that all markets were “not doing well.” Let’s correct that misconception, and then talk about your best behavior as an investor.
The fact is that 2014 has been a pretty good year so far for the stock and bond markets, and not a bad one for the Canadian dollar.
The Canadian stock market is healthy, finally reaching the levels it hit in 2008. The S&P/TSX index closed out June 30 at 15,146 points, up about 11.6% from its December 31, 2013 close of 13,622.
A big difference between now and 2008 is that total corporate profits are much higher now. These profits are supporting the stock prices much more solidly than was the hollowness of unfounded optimism and false profit claims back in 2008.
Let me hasten to say that a stock market correction could still happen at any time, as always, but conditions seem very different than in 2008.
The Canadian dollar finished up June 30 at 93.8 cents US, having started the year at 93.9 cents US. However, many of us had our perceptions molded by the headlines of the falling dollar earlier in the year, when it actually dipped below 90 cents before recovering in the last few months.
The US stock markets have also been robust, with the S&P 500 hitting 22 separate record highs this year. It closed June 30 at 1,973, up about 6%.
Made up of a capitalization-weighted and “float-adjusted” index of 500 large American companies, this is the most widely followed indicator of the strength and breadth of American industry.
The Dow Jones Industrial Average, made up of 30 of the largest companies in America, rose about 1.6% in the six months, and ended up in record territory.
So what does all this tell you?
Among other things, it suggests that a slow economic recovery and a healthy dose of pessimism can be the best tonic for the stock markets. To my mind, that’s a much better atmosphere than the gin and tonic-powered periods of irrational exuberance that typically indicate a market top.
You can say that the “stock market” level is supported by two main factors. The first is the total amount of profits being generated by the companies whose shares make up that market. Generally, higher profits support higher share prices.
The other factor is the valuation level, which is the price that buyers are willing to pay for each dollar of profit. The most common measure is the price-to-earnings ratio.
In times of pessimism, the market is not willing to pay very much for a dollar of earnings. This is rational when profits are declining, which happens when an economy is falling into recession.
However, paying a small amount for earnings can be irrational, when it is just an emotional reaction to recent negative returns in the markets.
In times of optimism, the market becomes willing to pay much more for each dollar of earnings. Again, this may be rational when the economy is expanding quickly and profits are growing. In that case, the market is anticipatory and making good investments.
Such optimism may be irrational, though, as it was in 1999, 2007 and 2008, periods when the market had been rising for a long time and investors had forgotten the level of risk involved in investing in stocks. Such periods are characterized by a belief that the market will go up forever.
However, markets do not go up forever, nor do they rise in a straight line. Corrections, large and small, can happen on any day, and often when least expected.
As an investor, your job is to determine with your advisor how much of your portfolio can be exposed to these ups and downs, and how much needs to be more solid, even capital guaranteed, investments.
This is based on your own circumstances, including your time horizon, need for liquidity, need for income from the portfolio and your personal tolerance for risk.
Base your portfolio design on those factors, and not whether or not the stock markets appear “high” or “low”, then rebalance your portfolio back to your target mix as corrections or expansions occur. Then you can ignore statements, either informed or uniformed, about “the markets”.
* * *
Dollars and Sense is meant as an introduction to this topic and should not in any way be construed as a replacement for personalized professional advice.
Please consult legal, tax and investment experts for advice on your unique situation.
David Christianson, BA, CFP, R.F.P., TEP, CIMis a financial planner and advisor with Christianson Wealth Advisors, a Vice President with National Bank Financial Wealth Management, and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.