As the Dow Rises, Will Confidence in the Markets Persist?Published: November 11, 2009 in Knowledge@Emory
On Oct. 14, the Dow Jones Industrial Average hit 10,000 and market watchers were eager to interpret it as a sign the U.S. economic recovery is gathering steam. But is the Dow's upward movement a reason for confidence, or do major obstacles still lie ahead?
According to Clifton Green, a professor of finance at Emory University’s Goizueta Business School, the precise value of the index of top U.S. stocks has no significance in itself. “These sorts of milestones are always psychological,” says Green. “There’s nothing fundamental about the Dow hitting 10,000.”
However, other professors argue that the 10,000 figure may still matter to an extent, because in the short run, psychology--or what economist John Maynard Keynes famously described as “animal spirits”--often drives the market as much as objective facts. “The Dow hitting 10,000 can be important because psychology plays such an important role in the market,” notes Goizueta finance professor Jeff Busse. “Sometimes, in terms of technical analysis, these round numbers tend to be either support or resistance levels.”
Viewed in that light, the Dow’s fifth digit may have given consumers and investors a boost of confidence.
Indeed most market-watchers at Goizueta are at least cautiously bullish. Since March, U.S. stocks have risen almost 60% in the U.S., but scholars don’t consider the market overvalued. Narasimhan Jegadeesh, a chaired professor of finance, says U.S. stocks are priced now at 14-15 times projected earnings (roughly a 7% earnings yield), which seems to him about right. “I think it’s fairly valued now,” he says.
One source of Jegadeesh's confidence is the fact that many leading economic indicators are trending upward. He notes that eight of the Conference Board’s ten leading economic indicators are sending a positive signal for future growth.
Goizueta faculty seem even more optimistic about prospects overseas. “The global economy as a whole looks stronger than the U.S. economy," says Jeffrey Rosensweig, a professor of international finance and director of Emory’s Global Perspectives Program. "A few of the most populous nations on earth never even fell into recession and are growing nicely now. In that category, we see not only China, but also India and Indonesia with accelerating growth.”
Much of the appeal of emerging market investments, particularly in the BRIC (Brazil, Russia, India, and China) economies, is still centered on additional prospects for their exports. However, Jegadeesh says investors are also increasingly interested in the prospect of more domestic investment. “I think the export story is always going to be there, but the dependence is going to be reduced because their domestic wealth is going up,” he says.
For investors, confidence often translates into action. But Rosensweig cautions that now may not be the right time for an investor to jump in. “Just because economies are rebounding in the big emerging markets does not mean that their stock markets are necessarily good buys now,” he says. “Many of them have risen even more than the U.S. stock market since the troughs this spring. Indeed, some of the key markets, such as China and Russia, have roughly doubled. It is always hard to forecast where markets are going, so there is a chance that they will just keep going up, but I also see significant risk in markets which jumped so quickly and so strongly.”
Domestically, Busse also cautions that there is a risk stocks won’t live up to expectations. Many of the positive earnings seen last quarter were driven by cost-cutting, he says. Investors will need to see sales growth this quarter to justify current stock prices. “If the earnings that come out in the next month and a half don’t back up the move in the market since mid-July, I’d think it’s kind of a tenuous situation."
Despite such warnings about volatility, most professors believe the risk of a large-scale meltdown is now mostly gone. “I think we’re through the systemic risk part of it,” says Ray Hill, an assistant professor in the practice of finance at Goizueta and former CFO of Mirant Corporation. More banks may fail, Hill says, but the risk of an out- and-out collapse seems mostly over. “I think it’s pretty clear that we’re not going to have a meltdown in the system,” he says.
Although America may have dodged a major bullet, bankruptcies may still have an outsize impact on the economy. Charles Goetz, a senior lecturer in organization and management and a distinguished lecturer in entrepreneurship, says that the recent declaration of bankruptcy by CIT Group could have “a huge potential impact” on the economy, because the bank is an important source of small business financing.
Of course, Wall Street is never without a set of worries, and many investors are now starting to think that the huge growth in deficit spending will trigger inflation.
Hill agrees that this is a challenge. He argues that sooner or later, continuing deficits will trigger either high inflation or high interest rates. "You will have one or the other," Hill explains.
But Professor Jegadeesh argues that it may not be a challenge yet. His Exhibit A: the spread, or difference, between TIPS--special government securities that is indexed to the rate of inflation--and ordinary T-bills doesn’t suggest that inflationary pressure is rising.
Inflation might have risen under ordinary circumstances, Jegadeesh says, but people are holding onto their cash more tightly than they normally do. The fact that money is moving more slowly from hand to hand is keeping the economy cooler than would normally be the case.
Certainly, Corporate America is keeping its wallet firmly closed. A Wall Street Journal examination of the 500 largest nonfinancial U.S. firms published Nov. 2 found that in the second quarter, companies held $994 billion in cash and short term investments, 9.8% of their assets, up from 7.9% of assets, $846 billion, the year before. Third quarter reports also seemed to be following the trend, with some companies holding even more than 10% of their assets in cash, up from an average of 6% in 1989. Some are playing their hand extraordinarily conservatively: Google now holds $22 billion in cash, 58% of its total assets.
Closely related to inflationary fears is the fear that the dollar will continue to lose value overseas. For most Americans, a lower dollar is arguably a good thing – the country’s exports are priced more competitively worldwide, and the government can pay its debts back more cheaply. But it wouldn’t be a good thing for global trade prospects, as the foreign creditors who now hold more than $1 trillion in U.S. government securities are unlikely to welcome a loss in their portfolio values.
For now, Rosensweig forecasts that the dollar will continue to fall over the long term but not much more in the short term. People who blindly extrapolate declines may not realize that free markets can always go two ways, he warns. “If it was so obvious that the dollar should be lower, then all the speculators would be selling dollars and they already would have pushed it lower than it is now,” he says.