Is this market boom for real?

There’s reason to think the good times may be here to stay
Is this boom for real?
Richard Drew/AP

The Nasdaq composite index crossed the 3,000-point mark last week, prompting a flurry of recollections about the last time the lofty milestone was reached. It was almost 13 years ago, Nov. 2, 1999, just as online grocery business Webvan was putting the finishing touches on its initial public offering—one of dozens of Silicon Valley companies going public with a half-baked idea and plenty of investor enthusiasm. Webvan’s stock soared in its first few days of trading. But a year and a half later the company filed for bankruptcy, joining the ranks of (online pet supplies), (fashion apparel) and (an online currency) as one of the tech bubble’s biggest flame-outs.

This time, though, things look different. The roaring stock market is being led not only by flash-in-the-pan start-ups, but immensely profitable companies like Apple Inc., now the most valuable corporation on the planet. Nor is it just a tech story. The S&P 500 Index has rallied 25 per cent over the past five months, as has the Dow Jones Industrial Average. In fact, taken all together, U.S. stocks have clawed their way back to pre-2008 levels, according to the broad-based Wilshire 5000 Total Market Index (Canada’s S&P/TSX composite index, by contrast, is up 65 per cent since the crash, though it’s down slightly over the past year).

So much for gloomy predictions about a decades-long recovery—at least as far as the markets are concerned. It barely took three years. Of course, the eternal question is whether the good times will continue. Many believe they will, arguing that U.S. corporations, having cut costs to the bone during the recession, are therefore poised to continue reaping the rewards as the U.S. economy gains traction. Just imagine, say the bulls, what will happen once the U.S. economic engine is once again firing on all cylinders, and the U.S. housing market turns around. “There’s a lot of runway,” Jim Cramer, the excitable host of CNBC’s Mad Money, recently told viewers.

Of course, Cramer has been spectacularly wrong before (urging people to buy stocks right up until the 2008 meltdown on Wall Street, for instance). And it’s not like the macro-risks have suddenly disappeared as governments around the world struggle with huge debts. Still, there is potentially good news in the markets for investors who have, in recent years, parked their money in low-returning government bonds or other so-called safe investments that are now threatened by inflation—providing, of course, you can stomach the roller coaster ride.

Though the world’s hottest company right now is Apple, whose shares have skyrocketed nearly 60 per cent over the last three months, there is a whole host of less sexy corporate names that are also offering surprisingly robust returns. Microsoft Corp. posted a 23 per cent increase in 2011 profits. General Motors earned US$7.6 billion last year, its best ever. Not bad for a carmaker that faced liquidation just three years ago. Overall, the earnings of the corporations tracked in the S&P 500, which also include stalwarts like Exxon Mobil Corp., Johnson & Johnson and Procter & Gamble, grew by an average of 12.7 per cent last year, while dividend payments soared by 18.3 per cent.

Even more encouraging is the fact that the recent bull market does not appear to be based on wild theories about a new economic paradigm emerging. That’s in contrast to the tech boom of the late 1990s, when investors believed the future of all business would be online, or even in the run-up to the 2008 crisis when soaring commodity prices left the impression the world was rapidly running out of key resources, including single family homes in the United States (turns out there would be plenty of opportunity).

And yet, for the most part, investors continue to run away from stocks toward the perceived safety of fixed income, with some reports suggesting that as much as US$10.6 billion has been put into U.S. bond funds so far this year while US$8.3 billion was taken out of U.S. equity funds. That has translated into rising bond prices and record low yields, making stocks suddenly look like a bargain—even at current prices. “People are very leery of equities and have fallen in love with safety, but sometimes you have to be a little bit of a contrarian investor,” says David LePoidevin, a portfolio manager for National Bank Financial. “Technically, a company like Johnson & Johnson has a higher credit rating than the U.S. government. So why would you flock to a two per cent government bond when we can get double the yield in Johnson & Johnson shares?”

The big question continues be to whether the U.S. recovery is for real, and can support such a booming market. It certainly seems that way lately, with the number of applications for unemployment benefits dropping to a four-year low and an average of 245,000 jobs being added for the past three months, a rate not seen for two years. “Usually you can take the stock market, to some degree, as leading the economy because stocks evaluate the future, not what happens right now,” says Andreas Park, an associate professor of economics at the University of Toronto who researches the financial markets. “The stable growth of an index usually indicates that there will be stable growth in the economy.” Similarly, Dawn Desjardins, an assistant chief economist for Royal Bank of Canada, says the latest data all seems to suggest a recovery that’s finally taken hold. “We’re seeing companies start to hire and business investment continuing,” she says. However, don’t expect the same sort of growth out of Canada, she adds. “Our economy is further along the curve of the economic cycle than our U.S. neighbours.”

Others remain deeply skeptical. David Rosenberg, chief economist at Gluskin Sheff, says an unusually warm North American winter has fooled many into thinking the U.S. economy is in better shape than it really is. Instead of holing up at home in front of their TV sets, consumers took money that would have otherwise been spent on heating oil and bought new clothes and restaurant meals. “When you’re getting March and April weather in January and February, it distorts the seasonally adjusted data,” says Rosenberg. “This will all come out in the wash during the second quarter.” As for corporate earnings, Rosenberg says that when something is at a record high, there’s a good chance it will go down. “It’s as close to a no-brainer of a call that you can make that margins are going to be compressed this year,” he says, arguing that rising oil prices and the need for companies to begin hiring more workers are going to raise costs and eat into profitability. That in turn, could depress stock indexes, which tend to track earnings.

All of this takes place against a global backdrop of instability and unknowns. In Europe, the threat of recession looms even though the Greek debt crisis appears to be finally coming under control with the latest big bailout. Investors are also closely watching China, where the official economic growth rate was recently slashed to 7.5 per cent for 2012, its lowest level in eight years. And, finally, there are nagging questions about how debt-soaked governments plan to balance the books, or how central bankers are going to successfully withdraw the billions’ worth of stimulus that have been injected into the system. For example, the Dow posted its longest losing streak in nearly three years following last year’s deal to raise the U.S. debt ceiling, which was viewed as too little and nearly too late.

Desjardins, for one, acknowledges there are significant risks, but argues they should be manageable. “It will take a considerable amount of time, and won’t be an easy task, but we’re not really anticipating anything that will disrupt the financial system,” she says.

Closer to home, there’s yet another reason why Canadians might want to start thinking about the U.S. stock market again. In a report this week, Craig Alexander, TD Bank’s chief economist, called the over-valuation of the real estate market a “clear and present danger” to the Canadian economy, suggesting that, if unwound rapidly, “it would be three times the correction in the early 1990s.” However, he stressed that there’s no catalyst for such a drop on the horizon—namely a sharp rise in unemployment or interest rates, which is why most economists predict a gradual decline in activity over many years.

Either way, stuffing all of your life savings into a house might not be a wise strategy at these prices. As the recent market rallies prove, stocks may suffer heart-churning crashes, but the comebacks can be just as surprising and exhilarating. As always, the challenge is knowing when to get in and when to get out.