Yesterday, the market—or at least the S&P 500 and the Nasdaq 100—hit new records. Again. But should we care? And do these most recent highs tell us anything about the future?
Should We Care?
The argument that we should care is essentially technical in nature. Before we hit a new high, in this view, there are people who bought at higher prices, only to see the market decline. Those people, in theory, will sell when prices recover to the level they paid, creating resistance. If we are now at a new high (the theory goes), there is no resistance to going higher; therefore, we should keep moving up.
This argument has merit, especially with individual stocks, but is less applicable at the index level. Markets do tend to rise over time, following the expansion of the economy. So, to apply seller resistance at that level is to ignore the systemic nature of what is happening.
Are New Highs A Useful Indicator?
Just for fun, I went to the blog and searched for posts that included the phrase new high. Hits included September 2019, April 2019, and September 2018—and that is just in the past two years. In a bull market, which we've been in since 2009, you do get regular new highs, and they do mean that the bull market continues. We can take the latest high as confirmation that, despite everything, the bull is not over yet. In that sense, we should pay attention. But since a new high really doesn’t tell us anything about the future, we shouldn’t pay too much attention.
Where a new high might be useful? In a bear market. In that case, a new high can indicate that a market is now back in expansionary mode. For example, in the most recent recovery, when the S&P 500 went above the prior peak in February 2013, it signaled that confidence was back. The gains since then have only confirmed that signal. On the other hand, we could also say that new highs signal increased risk, as they did in May 2007 when the S&P 500 rose above the prior peak in July 2000, just before collapsing again. Hmm. Perhaps new highs are not a good indicator after all.
Indeed, there are a few reasons new highs may not be a useful indicator. First, stock prices are nominal. They do not reflect inflation. As such, the new high might actually be lower than the prior high, in terms of what it can buy. Second, stock indices don’t include the effect of dividends, which is material over time. Third, and most important, stock indices are derived from a more fundamental stat: corporate earnings. Those earnings are then translated into prices through a multiplier, known as the P/E or price-to-earnings ratio. You can get the same index level through low earnings and a high multiple or through high earnings and a low multiple. Each scenario means something very different.
Earnings And Valuations: No New Highs Here
When we look at a new high in stock prices, therefore, what we should be looking at are earnings and valuations, which (by no coincidence) we do evaluate on this blog. Here, the news is less exciting. Both are much closer to the middle of the road—no new highs here! Even as the news is less exciting, though, it is a much better description of where the financial markets truly are.