As the bull market in US equities charges into its sixth year, I’ve been chewing on what drives stock prices higher.

“Duh,” you say, “more buyers than sellers.”

Sure, but what kinds of tailwinds encourage buyers to load up?  And how hard are those winds blowing today?

  1. Going into a recession, the stock market tanks in anticipation of a decline in corporate earnings.  Then in time the recession ends, earnings rise, and the stock market recovers.  So recovery from a bear market is driver #1.  Today?  Well, following the smash in 2008, US companies did enjoy strong earnings recovery from 2009-2012, but not much in the past two years.  Corporate profit margins are now at all-time highs, but earnings growth is pretty anemic and consumer income growth remains stagnant.  In an economy heavily dependent on consumer spending, that’s a problem.
  2. In a recession, the Fed lowers interest rates to get things going again.  The stock market loves cheap money–and so when interest rates are falling or when they are very low, that’s an important driver of higher stock prices.  But we’ve had that already–rates bottomed out in July 2012.  Now the question is: when exactly will the Fed start raising rates?  As soon as the stock market gets even a whiff that this might be coming down the pike, it could well nosedive–well in advance of when the Fed actually acts.
  3. Fiscal stimulus drives stock prices higher.  In a weak economy, government often steps in to spend more, offsetting declines in corporate and consumer spending.  Not these days.  Having  endured harrowing cuts after the financial crisis to meet constitutional requirements to balance their budgets, most state and local governments are now in better health than a few years ago, but they’re certainly not on any kind of spending binge.  Meanwhile, political opposition has prevented the federal government from borrowing at rock-bottom rates to invest in infrastructure projects that would help create jobs.  So we can take fiscal stimulus off the table as a current driver of stock prices.
  4. Global trade.  The addition of the former Soviet Union countries, then China, then India to the global economy dramatically increased demand for all sorts of goods and services.  Today?  Today we’re worried about retrenchment in China and stagnation in Europe, which could lead to a contraction in global growth rates and a further decline in raw materials prices.  Confrontation with Russia over its annexation of Crimea isn’t going to help either, and so it’s hard to see much tailwind for stock prices from this source.
  5. Multiple expansion.  When the stock market goes from selling at a price-earnings multiple of 8 to a p/e of 16, the price doubles, even if there is no earnings growth.  In the past two years, most of the rise in US stock prices has come from this driver.  Not from rising earnings or expanding global trade, but simply from a rising price-earnings multiple.  Today’s p/e multiple is now above the long-term average and right about the same as when the market peaked in 2007.  That’s unhealthy.
  6. Leverage.  When investors borrow money to buy stocks, they take on what’s called margin debt.  Obviously, this increases the amount of money available to buy stocks, which can drive stock prices higher.  But when stock prices drop, these leveraged investors have to sell fast to avoid going bust, and that can accelerate the decline.  So where are we today?  Well, data from the New York Stock Exchange shows that margin debt on the NYSE is now $451 billion, which is an all-time record.  This is a classic warning light.
  7. Investor sentiment and momentum.  Individual investors, in particular, are notoriously momentum-driven; when stock prices rise, they feel more comfortable investing in the market.  This is completely wrong, of course:  as stock prices rise, risk increases.  But that’s not how investors feel, and so tracking investor sentiment is a time-honored way of gauging the market’s vulnerability to a decline.  The more optimistic and complacent investors feel, the greater the danger of a pullback.  Today, most sentiment measures are in the danger zone.
  8. And it’s worth noting what other kinds of enthusiasm investors are evincing.  For example, the IPO market has been sizzling–especially in biotech.  But 74% of impending IPOs are for companies with no earnings, and that’s the second highest ever, after the late 1990s.  In other words, speculative fever is running hot.
  9. Similarly, investors are chasing after yield in junk bonds, where the quality of newly-issued bonds has deteriorated significantly even as their yields hit historic lows.  A good deal for the issuers; for the buyers, not so much.


The US stock market is overvalued and continues to rely on the stimulus of cheap and abundant money supplied  by the Federal Reserve.  The bull market might well chug along for a while longer–don’t underestimate that momentum effect–but it’s getting long in the tooth and some of the classic danger signals are beginning to flash orange and red.

By the way, in the five years since the market bottomed on March 9, 2009, the S&P 500 has recorded a total return of almost 210%.  That’s the fifth best five-year bull market run since 1900.  And with the exception of 1982-87, the others soon gave up much of their gains in bear market declines of 25% to 70%.

So don’t be complacent about the great returns you earned in 2013.  What the market giveth, the market taketh away.  Look at your long-term asset allocation targets.  Are you overweight stocks?  If so, rebalance back to your target allocations by shifting money from equities into bonds (but not all long-term bonds), and perhaps some cash.  Remember the old adage:  bulls can make money, and bears can make money, but pigs get slaughtered.  In other words, it’s time to be more fearful than greedy.