Why Is the Stock Market Hitting New Highs?


One would think that things were just ducky in the economy, judging from the rise in the stock market.  Indeed, the S&P500 keeps hitting new highs, as do the rest of the major indexes.  Even housing seems to be on a recovery, with prices in depressed areas such as Phoenix rising 20% year-over-year.  Obviously wages must be rising as businesses expand and try to lure talent away from other companies.  College seniors must be coming out of school, excited by all of the job opportunities they have in front of them.  Unemployment must be at multi-year lows and products must be flying off the shelf.

Unfortunately, this is not so much the case.  Unemployment is still well above 7%, and the real unemployment numbers are somewhere in the teens if you include the people who have quit looking for work and have gone from the unemployment roles to the disability roles or are working part-time jobs.  With layoffs and hours being cut as employers try to come in under the 50 employee limit at which Obamacare kicks in, there will be more and more people working less than 30 hours per week or not working at all.

Businesses are managing to get along without hiring a lot or new workers, and recent college grads have moved into their old rooms and settled in for the long haul.  At least their parents will have someone to water the plants and walk the dogs when they start to travel in their retirement.

So why is the stock market doing so well?   The reasons, as they often do, lie with the Federal Reserve.

The Federal Reserve control interest rates by controlling the supply of money and also by making loans directly to the banks.  If the Fed wants to take money out of the system, they simply tell the banks that they need to buy some federal reserve notes from them, which the Fed creates out of thin air.  If they want to add money, they buy the notes back or tell the banks they don’t need to keep as much in reserve in their vaults.  Lately they have even been creating money out of thin air by creating money and then using that cash to buy US Treasury debt when no one else will.  They also set the rate at which they loan money to banks, which in turn sets the interest rates for everything else.

The Fed does not have control over inflation, at least not directly and not with any precision.  If they add a lot of money and productivity does not increase (meaning there is no good place to put all of the extra cash), inflation spikes.  They can quell inflation by raising rates and causing the economy to crash, but this is obviously very crude.  It can also backfire, resulting in stagflation as Japan has dealt with for about 30 years where prices rise while the economy sits.

Equities (stocks) are things of value like anything else.  As inflation builds since the Fed has been pumping all sorts of money into the economy trying to make it recover from the housing bubble, the price of stocks goes up along with everything else.  If a slab of beef costs $20 instead of $10, the price of a share of XYZ might also go from $10 per share to $20 per share.  That doesn’t mean you can then buy more steak dinners with the value of your shares.  The value of both things remains the same relative to each other.

The other reason that stocks have been going up is that people are looking for a way to earn some income on their holdings.  Savings accounts have been paying nothing for a long time.  Retirees need some way to generate income to pay for things, and they just can’t cut it with a $1 M bank CD paying $10,000 per year.  They have therefore started to put money into stocks to increase their returns.  The trouble is this means they are taking on more risk, which may not end well.

So, enjoy the rise, but realize that some of the rise is just inflation, meaning you really aren’t making money.  The rest of the rise is due to interest rates, which could all disappear if the Fed raised rates again (or the market forces rates up because inflation starts to accelerate) and savers rushed back into traditional money markets and bond funds.  The real gain for stock investors will come as people create value and businesses grow.  Sadly, this is not happening yet to any meaningful extent.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Top Posts for the Month


Here are the most popular posts for the month, with the number of views.  There seems to be a lot of interest in getting involved in stock investing by newcomers, given the interest in “How Much Money Do I Need to Invest in Stocks.”   There is also concern about inflation and risk.  Given the low interest rates and frothy markets, these are good things to worry about.

How Much Money Do I Need to Invest in Stocks? 189
How Inflation Affects the Stock Market 95
Making the Most with $2,000 in Investing 58
How an Investor Can Reduce Risk 51
How to Reduce Your Risk when Investing in Stocks 44
Why Do Stocks Sometimes Go Down on Good Earnings? 40
Why High Beta Stocks have Higher Returns 35
Stock Price and Earnings – How Current and Future Earnings Affect Stock Price 31
Capitalism and the Office Microwave 28
Should I Borrow Against a Paid-Off House to Invest 28
What Poor People Say; What Rich People Say 27

 

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Why Small Stocks Do Better than Large Stocks


Looking at returns since the 1920’s, small cap stocks have done better than large caps by about two percentage points.  This is not to say that they always do better during any given period of time.  In fact, there will often be cycles where small caps will beat large caps, then large caps will beat up on small caps for a while.  Over long periods of time, however — like 50 years — small caps will win out.  So what gives?

Remember that the pricing of securities is all about risk and return.  The greater the risk for a given security, the more return investors require before they will purchase them.  For stocks, the lower the price relative to the potential earnings, the greater the return when earnings are met.  This means small stocks will be priced lower – relative to expected earnings – than will large cap stocks.

Greater risk also means, however, that there is a greater chance that any given small cap company will go out of business than that any given large company will do the same.  If there is a downturn in the economy, large companies like GE can sell off divisions, lay people off, and draw from cash reserves to stay alive.  They are also able to get loans fairly easily since people expect them to be able to pay them back.  Small companies may only make one or two products and just make payroll each month, so a downturn may wipe them out.

Because these stocks are priced for a higher return, a basket of them, over a long period of time, will outperform large cap stocks.  The small caps, after all, have a lot more room to expand and grow than do the large caps.  It is really difficult for Coal-Cola to double earnings.  It is relatively easy for a restaurant franchise just starting out.  The trouble is figuring out which stock will become the next giant and which will fizzle out.

To decrease risk, one can buy a whole basket of these small caps, rather than trying to pick individual stocks.  This is done by buying a mutual fund that invests in small caps. (Look for names like aggressive growth, small cap or micro cap in the name.  Also, check the box which tells the size of stocks and investing strategy (value or growth) in the prospectus for the fund.)  You can also purchase an index fund such as the Vanguard Small Cap Index Fund.

This is not to say that you should only have small caps in your portfolio.  Because other segments of the market will outperform small caps some of the time, it is good to include some large caps as well.  As you get closer to needing the money, and have more money to protect, buying more of the larger companies is wise wince this will decrease the chances of large losses during market downturns, as will diversifying into income assets.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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