B-U-L-L: Anatomy of a Bull Market

Today’s investors have not seen a bull market in a very long time.  Some have never invested through one at all.  The last time we saw a true bull market was in the 1990s right before the technology bubble of 1999-2000 took hold.  The stock market downturn in 2008-09 was more of a shock-fear reaction to the financial crisis than it was the end of a bull market. 

The market is certainly in a bull market today.  We’ve used the acronym B-U-L-L in the past to describe the characteristics of a bull market and help us understand market behavior.

U.S. Corporations Going Global for Growth

Since 2009, stock prices are up well over 100%.  The stock market has moved higher for a variety of reasons - including an economy that has improved dramatically from the Great Recession and continued stimulus from the Federal Reserve to keep interest rates low (read our post on the economy and interest rates here). 

The primary driver for growing prices has been improving fundamental values.  Long-term stock market appreciation cannot exist without increasing dividends and earnings.  As we have said many times, dividends have shown to be highly correlated with stock prices over the long-term.  Since dividends are real cash paid out to shareholders, they ultimately must be backed by actual corporate earnings.

Is The Market Overvalued?

The stock market is in constant conflict between buyers and sellers.  Aside from very short-term traders, these purchases and sales are based upon the perceived value of the underlying company being greater or lesser than the current trading price.  In aggregate, all these many purchases and sales determine stock prices. 

Whether or not the market is very good at accurately pricing a particular stock close to its intrinsic value has been thoroughly debated, but our opinion is that the market gets it wrong many times.  An overall bullish sentiment about a particular company will drive its stock price beyond its intrinsic value, while another stock will get hit hard by missed earnings or other pessimistic news.

What drives these wild fluctuations above and below fair value?  Two major forces: fear and greed.

Why Weak Economic News Might Be Good for Stocks

As we mentioned in last week's article, we are providing our most current outlook on global economic growth.  We will update our projections periodically to reflect our latest views.

Economic indicators have been very confusing for investors.  “Good news” about economic growth has been perceived by the markets as “bad news”, as it could lead to reduced monetary stimulus from the Federal Reserve.  In this article, we will identify some key economic information and separate each point into good news and bad news, then come to a final consensus as to our specific views about the economy and how it will impact stock market growth moving into 2014. 

1. Slow Economic Growth

Economic growth in the United States has been mostly flat coming out of the recession in 2008-09.  In the 2^nd quarter of 2013, real GDP growth was a mere 2.5%.  The economy has been “muddling along” for quite some time.  We anticipate slow economic growth will continue into 2014. 

Driving the Bull: Dividend Growth Pushing the Market Higher

Now that the government shutdown is past us and the debt ceiling has been pushed out for the near term, we thought it would be an interesting exercise to share with our readers some recent research that we have done in attempting to identify which types of stocks are doing the best in the current bull market.  

S&P 500 Total Return Analysis

The stock market has had a strong run since 2009.  Over the last 12 months, the S&P 500 is up approximately 25%.  We broke the S&P 500 companies down into quintiles of 100 stocks each and ordered them according to largest to smallest in 4 different fundamental categories including sales growth, earnings growth, dividend yield and dividend growth.  We then calculated the total return (dividends and capital appreciation) for each quintile over the last 12 months.

So Goes the Dividend, So Goes the Stock

The Government shutdown and looming default deadline are consuming the majority of headlines.  Our stance remains unchanged: we believe U.S. politicians will eventually reach a deal.  For more details, you can read last week’s article here.

Rather than join the ongoing government shutdown discussion, we want to take a step out of the short-term gloom-and-doom to look at what impacts long-term stock market growth or decline: earnings and dividends.

Our statistical models show dividends to be a highly significant predictor of long-term stock prices.  The chart below shows the basic correlation between nominal dividends paid and the S&P 500 index price over the past 20 years.

Government Shutdown & Default Fears Could Create Opportunity

Portfolio Changes

The strong bull market over the past 5 years has driven a handful of our companies’ valuations to fair or even over-valued in our statistical models. These stocks have done very well for our clients, however, there is a time to take profits and we believe that time is now for some of these companies. As a result, we are in the process of selling a few positions in favor of stocks with better long-term outlooks.