It’s been a good year so far. But some say this is crazy.
The U.S. stock market ended March with its best first-quarter performance since 1998. In the first three months of the year the Dow Jones, Industrial Average rose 8 percent, the Standard & Poor’s 500 index 12 percent.
Even more surprising is the 19 percent increase in the Nasdaq Composite index, its best yearly start since 1991. The rapid rise in this segment of the market due in large part to high-flying price of Apple Computer’s stock.
This fast start to the year for the market begs the question, “Is the market nuts?”
Economic conditions don’t seem to favor this kind of stock market performance. At over 8 percent, unemployment remains well above what most economists see as normal. At 2 percent or less, the growth rate of gross domestic product is well below rates usually seen after recessions.
Financial economists generally assume that investors are rational and markets reflect all current information accurately. So either investors see things turning up soon, or they’ve gone crazy again.
Research in behavioral psychology may explain part of the current upward trend in stock prices.
One important area of research is the study of our attitudes towards risk. Studies have found that the pain of loss is often much greater than the joy of gain. Translating this to investment choices, investors will only take more risk when they have already made good gains. This can lead for extended upward gains in the market. When the market goes up we buy more.
Unfortunately, the same may happen when prices go down. Investors stop taking risks as they take on more losses, which causes the markets to fall even further. In all, the tendency of investors to look only at current trends to exacerbates these trends, making the market more volatile than it would be otherwise.
Another example of psychology at work in the market is in our beliefs about probabilities. When we witness an event that rarely occurs, we overreact. If we see big gains, we expect big gains. If we see big losses, we expect big losses. Even though both extremes are rare.
It can be argued investors irrationally sold off stocks after the financial crisis of 2007-2009. These same investors then piled into bonds, thinking the risk was lower. But we now have a new “bubble” in the bond market.
Things may be reversing themselves. Fortunately, the runup in stocks in the first quarter of this year has not led to extreme overvaluation.
Two key measures of stock values are the price-to-earnings ratio and the dividend yield. Stocks in the Dow currently sell at an average rate of 17 times earnings and yield over 2 percent on their dividends, very near the long run average for both.
Some stocks of local interest sell at even better values. IdaCorp Inc., the parent company of Idaho Power, is priced at only 12 times earnings and has a dividend yield above 3 percent. Hewlett Packard has a PE ratio of only 9 and a 2 percent dividend yield.
Investors may not always act rationally, and the runup in stock prices this year may not last, but prices are nowhere near extreme, and values can be found. Stock investors may be on to something – an improving economy.
Peter Crabb is professor of finance and economics at Northwest Nazarene University in Nampa.