EmailStock market indices are not a collective vote on global economic and political conditions. They are summations of the value of individual companies. The reason the stock market has trended higher the past three years is that the fundamentals for individual companies have improved. The rally and improved fundamentals have occurred, and can continue to occur, even in the face of continued macroeconomic problems.
Bearish Obsessions
Bears complain that the stock market rally since the start of the year, and for the past three years overall, has occurred despite continued global economic and political problems.
There is, in fact, no doubt that significant problems persist and may not be getting better. The situation in Greece remains problematic, Europe faces a long period of slow economic growth due to austerity programs, tensions are rising in the Middle East, U.S. unemployment remains high, and the U.S. budget deficit shows little sign of immediate improvement.
How, then, the pessimists argue, can the move higher by the stock market possibly be justified?
The Bullish Factors
The chart below is real. A quick glance at the trend over the past year might suggest that a bubble is occurring. After all, there has been a sudden move higher.
There is in fact, no bubble. The chart above is a chart of Apple stock, indexed to 100 starting a year ago. Apple stock has moved higher over the past year because the fundamentals for the company have improved.
For 2011, profits at Apple were up 119% compared to 2010. The stock today is up 40% from a year ago.
This isn't a bubble. It is a stock price moving higher in response to substantially higher profits. In fact, there is an argument that the stock hasn't fully priced in the higher level of profits and is undervalued.
A similar argument exists for the S&P 500 index -- the recent stock market rally is fully warranted on the basis of fundamentals and is in no way a bubble.
In fact, the S&P 500 is up only 2% from a year ago despite the fact that profits for 2011 are up approximately 14% over 2010. (The index is up about 8% from the beginning of 2011).
The recent rally in the S&P 500 index does not reflect a bubble. The rally is due to individual stocks rising as a result of an improvement in profits over the past year.
Further Evidence This Is Not a Bubble
A bubble can be loosely defined as excess demand for an asset pushing the price beyond intrinsic values, based partly or largely on the expectation that the price will move higher in the short term.
That is what happened in the housing market in the years prior to the recent collapse. There was excess demand caused in part by government subsidies that pushed home prices beyond values relative to renting and incomes, and part of the buying was based on the expectation that prices would move ever higher.
This isn't at all the case in the stock market today.
In fact, volume in the stock market is extremely low. Volume on the NYSE is the lowest in over a decade. There is no rush to buy stocks.
Furthermore, as we have written numerous times, the value of stocks is well below historic norms (The Long-Term Case for Stocks and The Other Side of "Sell in May"). And there is hardly a widespread belief that you have to get in the stock market now before it is too late.
What is in fact happening is that the stock market (to anthropomorphize for a second) is RELUCTANTLY grinding higher.
Individual stocks are moving higher due to rising profits and dividends. That is pushing the overall indices higher.
Money managers remain underinvested in stocks, and are only moving to increase holdings with reluctance amidst a great deal of concern about the risks involved.
The stock market has made a very strong move over the past two months and it can easily be argued that the market is short-term overbought and due for a correction -- but the argument that the move is a bubble, or not justified, is without merit.
Risks Still Exist
The stock market rally of the past three years does not necessarily imply that risks have declined.
The "risk-off" comments that occur every time the market goes up reflect shallow analysis and are in fact misleading. The implication is that the move higher is unjustified if risks have not changed. In fact, the market has been moving higher despite continued risk.
Higher profits have pushed stock prices higher, and yet stocks remain at a discount to historic norms because of continued risk. In fact, the risk discount priced into stocks has not declined.
Furthermore, for understandable reasons, market commentary and analysis is heavily weighted towards the global economic issues that present risk.
Bears in particular are addicted to emphasizing global economic concerns because, at times, when associated risks increase, the stock market drops sharply.
In the summers of 2010 and 2011, the stock market dropped sharply on macroeconomic concerns. These short-term reactions to global news appear to validate the idea that the stock market is driven by global economic issues.
Bears live for those times when the macroeconomic issues dominate and the risks of global problems seemingly increase, and cause a sharp stock market decline.
Yet, it is not inconsistent that when risks appear to increase, the stock market goes down (often sharply and in a short period of time). Over the long term, these factors are not the major factors driving the market.
Over the past three years, U.S. corporate profits have risen sharply, and that is what has produced the over-100% rally in stock prices.
An Example
Higher risks from macro problems are legitimate, but they will only drive the U.S. stock market lower if the risk to profits increases over time.
That is not the case for most companies with respect to the Greek situation. The risk of a Greek government default causing a credit disruption in the U.S., or a significant hit to U.S. corporate profits is probably lower today than it was a year ago. As long as that risk is lower, it makes no sense for the bears to say (as they are fond of doing) every time the market goes up: "Does anyone really think the Greek problem has been solved?"
The Greek problem has not been solved, and may not be "solved" for a decade, if by "solved" one means that Greece has achieved fiscal stability.
Yet, Apple stock will continue to go higher if profit at the company continues to surge.
The idea that stock prices can't go higher given the existence of these risks is absurd. In fact, the S&P chart of the past three years proves that to be true.
What It All Means
The stock market has moved higher the past few years for very sound fundamental reasons -- earnings have risen sharply.
When a company has higher profits, the value of that company increases. As individual stock prices go higher, the 500 stocks that make up the S&P 500 push the index higher.
That is what has been happening the past three years. The market has been a market of individual stocks, and not a stock market driven solely by macroeconomic concerns.
Bearish sentiment typically ignores the trends in individual company fundamentals and prefers to focus on the troubling macroeconomic global economic conditions that are undeniable. But these factors won't drive the stock market unless risk increases or if the presumed implications for profits actually materialize.
One way of thinking about this is to ask, every time the stock market drops on news out of Europe: How exactly will this impact my dividend check from Johnson & Johnson (JNJ)?
It is only slightly a tongue-in-cheek question. The fact is that even a Greek default won't impact the JNJ dividend much if at all. It won't affect most U.S. corporate profits or dividends. And over time, if those profits and dividends at individual companies keep grinding higher, individual stock prices and thus the S&P 500 index will as well.
Recognizing that this is a market of individual stocks, and not always a stock market acting in aggregate driven by perceived global risks, explains how the stock market can be rising even while macroeconomic risks persist.
