The Stock Market’s Gyrations and Their Meaning

Tuesday, November 30, 2010

Monday morning, the Dow Jones Industrial Average (DJIA) “slipped,” “slid,” and “slumped” below 11,000. Then, in the afternoon, it “rebounded” and “recovered.” Are those descriptors accurate? Well, maybe. More likely, though, the stock market simply acted normally and fluctuated.

But there is an important question behind the stock market’s last few month’s of basically sideways movement: Is it a sign of a tired, topping market, soon to be followed by a drop? Or is it a sign of base building, soon to be followed by a new bull market leg? To me, it’s the latter, and here’s why…

Strong feelings result from market environments

The following graph illustrates how not just individuals’ emotions, but also experts’ analysis and conclusions can get carried away by what has been happening. The longer a stock market acts a certain way, the greater the expectation that it will continue. Hence, the “lost decade” viewpoint has become a driver of future predictions.

As the graph shows, the 1990s decade’s outstanding returns produced its own set of outlooks. Those unfulfilled forecasts now look silly but, at the time, were supported by facts and logic, with many investors embracing them.

Ignoring the past and focusing on the present provides a better outlook

We have been witnessing a continuing improvement from the dark days of late 2008 and early 2009. Even The New York Times (a perpetual latecomer to new trends) has been writing about the positive developments. Last weekend’s good retail traffic and sales is an example.

At the same time, companies have produced solid earnings gains, even where sales growth has been meager. Those earnings (and even dividends) well support today’s stock valuations. Reasonable 2011 economic growth expectations are leading to desirable earnings growth forecasts.

Signs of an overpriced stock market are missing

Investors continue to liquidate US stock mutual funds in favor of bonds and even foreign stocks. Such flows reflect the “lost decade” feelings, but (and this is very important) those flows, themselves, cannot produce the next decade’s stock market movements. Rather, they simply keep valuations attractive, even as earnings growth pushes stock prices up.

So… I believe the stock market’s gyrations are a sign of base-building. Unless something unexpectedly adverse happens (and problems like Ireland don’t count), the market could climb higher on earnings growth though 2011. At some point, the good stock returns will inevitably attract investors’ interest – and money.

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