Wall Street is in the sixth year of a bull market that – if it keeps up – in May will surpass the length of the boom that ended with the 1987 crash, but another sharp crash will likely be prevented by slips in prices like the small correction that continued on Monday to keep prices from overheating, stock historians and an economist say.
Stocks reached record highs last week before dipping back to Earth on Friday when the Standard & Poor's 500 index closed at 1,865.09, the Dow Jones industrial average closed at 16,412.71 and the Nasdaq Composite Index made the worst finish of the week at 4,127.73, dropping 2.6 percentage points in one day. Stocks continued to drop Monday, with the Dow ending at 16,245.87, the Nasdaq at 4,079.75, and the S&P 500 at 1,845.04, each sinking approximately 1 percent compared with Friday.
This pattern of periodic dips is likely to continue but the bull market might have further to run. This growth market began in March 2009 and has been haunted by the bad memories
of the recession. But that is starting to change as different sectors of the
economy, including jobs and housing, return to the high levels they enjoyed in 2007
or 2008, says James Paulsen, chief investment
strategist at Wells Capital Management. Since stock growth began in March 2009, the S&P 500 has risen from 756.55 to Monday's level of 1,845.6. Last year, the S&P index reached new heights.
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“Last year we finally gave up the Armageddon ghost,” Paulsen says. “You are starting to see the emergence of confidence in this country.”
The current bull market resembles the pattern of the '80s boom in some ways as there is a rush to get into the market now that times are improving, he said. But as Wall Street becomes more confident it will more likely head for a correction- a dip in prices after a peak in share value- rather than a crash, Paulsen argues. This bull market is more about mass psychology than balance sheets as fear and caution have kept overconfidence in check among small investors and many financial institutions compared with past booms, Paulsen adds.
“Investors are more confident than they were three years ago but there is not a reckless euphoria as in 1987 or 2000,” Paulsen says. “If we do get a correction I think we will get a spurt first.”
The market may not be headed for a dramatic crash, but there are signs of overconfidence that should lead long-term investors to buckle up for some dips amid the rise in prices. Similarities between the current market and the booms of the ‘80s and ‘90s, however, include a frenzied rush for companies to make initial public offerings of stock and a rapid rise in margin debt as investors borrow money to buy stocks, notes James Stack, president of InvesTech Research, a financial advisory firm he founded in 1979.
“While it’s too early to say where margin debt will ultimately peak in this cycle, we find it hard to envision another 18 months of parabolic rise,” InvesTech said in its newsletter on Friday.
Small investors, however, are more cautious because “they were burned so badly” during the crash in 2008, even though this is now the fourth-longest U.S. bull market of the past 85 years, Stack says.
“We might be in the later innings of the bull market, but it is still a bull market,” he adds.
Wall Street may be in the midst of some of the “psychological excesses often seen in mature bull markets,” but 12 corrections have occurred since 2009 to release steam on prices and keep the market from overheating.The most recent correction occurred in January, Stack says, as outlined in a chart below provided by InvesTech showing a timetable of price corrections since 2009.
“On average in the past 80 years, 5 percent corrections happen about every seven months while 10 percent corrections happen every two years or 25 months in a bull market,” Stack says. “Leading up to the 1987 crash we had a long period [without corrections]. What made the ‘80s different from today is we have very slow growth.”
The IPO market is hot and it’s especially ripe for Internet companies to go public, but valuations are not as speculative as they were before the 2000 bust of the dot-com bubble, Stack says. The price to earnings ratio of stocks on the S&P 500 is slightly overvalued at a ratio of 18.9 to 1, above the average ratio of 17 to 1 seen in bull markets during the past 85 years. That gives prices some room to climb higher, he says. The ratio measures how much investors are willing to pay for a company's earnings stream, so as a long as earnings go up the stock price should theoretically rise with them.
“One cannot use any IPO data or mania as a reason by itself to abandon a bull market,” Stack says. “As far as forecasting the next correction that’s virtually impossible.”
Economic growth is not as rapid as in the 1980s, but the economy is no longer in danger of going into a recession as housing and job markets improve, says Paul Edelstein, director of financial economics at IHS Global Insight. Wall Street is also reassured because there is little pressure on the Federal Reserve to raise interest rates in the near future, Edelstein says. Confidence in the stock market has been boosted by the unemployment rate improving from 8.5 percent in March 2009 to 6.7 percent in March 2014, according to data from the Bureau of Labor Statistics, while several reports on rising home prices and increasing building permits show housing market prosperity has largely returned to pre-recession levels.
A sense of financial safety is also in part due to government scrutiny of the economy since the recession, Edelstein adds, noting that the housing market has new safeguards on mortgage lending, banks are required to hold more capital and their balance sheets are being stress-tested more by the Federal Reserve.
“Stock market events don’t have to cause a recession like in 2007,” Edelstein
says. “You can argue there is overconfidence in the market now but relative to
2006 I don’t think it’s quite as bad.”