Beware the stock illusion

Mar 8 2013 - 1:27pm

The stock market, in normal times a reliable proxy for an economy's health, reached record levels this week. And why not? Corporate profits are higher than ever. The housing market is springing back. Auto sales are on pace for the best year since 2007.

At the risk of sounding like party poopers, these aren't normal economic times and the stunning four-year rally, during which almost $10 trillion has been restored to U.S. equities, is both a welcome trend and a reason for worry. Individual investors who are tempted to join the party should take special care.

A rising stock market gives off a rosy glow, and not just because it makes investors richer. It enhances what economists call the wealth effect: When household worth goes up, consumers open their pocketbooks wider. The increase in demand for homes, cars and other big-ticket items in turn leads employers to hire, which lowers unemployment and further drives consumer confidence. Quarterly 401(k) statements reflect the robust stock market, keeping the virtuous cycle going.

Share price increases tend to feed on themselves because they coax more investors into buying. In January, equity mutual funds, which cater to retail investors, registered an inflow of almost $38 billion, the highest amount in nine years, according to the Investment Company Institute, a trade group. The previous month, investors had pulled almost $31 billion out of these funds.

Now for the warnings. A rising stock market can be an illusion. This one is soaring largely because other forces are at work (or not working at all) in the political economy. The most important is the failure of lawmakers to use fiscal policy to stimulate demand. The Federal Reserve has been forced to step in.

The central bank's aggressive bond-buying and record-low interest rates are forcing yield-hungry investors to buy stocks. At some point, the Fed will reverse course by selling assets and raising interest rates. In turn, that will give investors other options beyond stocks, potentially driving down share prices.

None of this is to say don't invest in stocks. Nor is it to say a bubble has formed, like the technology boom of the late 1990s and the housing-fueled run-up of the mid-2000s. The evidence may even point in the opposite direction on this score: The price-to-earnings ratio -- what it costs to buy a dollar of a company's profit -- for stocks in the Standard & Poor's 500 Index is 16 percent below the level at the end of 2009.

The same goes for the Dow, which has more than doubled in four years, yet its valuation is 15 percent below the 20-year average. When adjusted for inflation, moreover, the Dow is still 9 percent below the previous all-time high hit on Oct. 9, 2007. In other words, stocks are still a bargain, historically speaking.

What we are saying is this: Arm yourself with the facts, some of which may be inconvenient to your stockbroker. Don't try to time the market by jumping in and back out when you think the peak has been hit. And by all means, imitate Warren Buffett and invest for the long term.

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