Like everyone else, I've spent the last few days trying to work out exactly what the Dow surpassing an all-time high of 12,000 points means for the markets. My conclusion is to follow the numbers. The numbers always seemed to be pointing to a year 2012 record high for both markets, fueled by a massive second coming in tech stocks, and it's satisfying that now the numbers are starting to add up in the right direction.
A lot of the skeptics are pointing out – with some justification – that it's not the Dow meeting record highs that's a key indicator, but it's when the the junior NASDAQ follows suit that we should start paying attention. In part, argue the skeptics, this is because of the misleading way in which the Dow is measured – as a total culmination of all stock prices regardless of market caps, meaning that an intrinsically smaller company with a higher stock price has more impact on the indices than a larger company with a lower price – and in part it's because the Dow is full of the heavy old industrial stuff which always grows over time anyway and that it's only when the 'New Economy' stocks start rocking and rolling that we know we're in the bull ring. Indeed, The Economist made this point only a couple of weeks ago.
But all this justified skepticism misses some major points, not least historic trends. First of all, there's not a lot of real net difference between a stock price moving up and and a market cap (a company's total value according to outstanding shares) moving upwards when a) the number of outstanding shares of the company's stock issue in play is much greater than the number of privately held shares (as is the case for nearly all Dow companies), and b) when you're trying to tell whether it's buying momentum you're seeing in the markets.
Let me explain the second point a little more clearly. If Company A is worth $100 a share but has a market cap of only $100 million, whereas Company B is has a price of $1 a share but is worth $1 billion, it may be easier to move the price of Company A's stock to $200 than it is to move the price of Company B's stock to $2, but this doesn't mean to say that there's not ferocious buying going on. If anything, it says buyers are becoming more speculative – and hence aggressive – with the returns they expect from their capital by courting assets with lower intrinsic valuations (assuming the comparative valuations of Companies A and B reflect to a reasonable degree their actual assets, which is the case with the Dow).
Secondly, to dismiss any kind of buying of an industrial capital market as not meaningful enough to gauge whether we're entering a bull market or not is grossly ignorant of the way in which economic growth in an economy takes shape. The first companies to attract investment in China five years ago, it should be remembered, were not the fancy technology stocks and souped-up financial vehicles that get the spot light in a raging bull market, but rather the industrial companies from which productivity stems. It's only natural for capital to seek out gains in material productivity before it seeks out gains in intellectual productivity.
Most importantly of all maybe, if you look at the correllations between the Dow and the NASDAQ it's impossible not to notice that the latter follow the former in almost acolytic fashion, particularly with regard to up/down swings:
Look at how in particular, in this chart going back to the first trading day of the NASDAQ, the blips in the Dow in 1987, 1990/1991 and 1998 all correspond magically with significant blips in the NASDAQ. Also look at how, after the 1998 blip a strong run can be seen on both the Dow and the NASDAQ. Lastly, and most importantly of all, notice that every time there's a pre-emptive greater spike in the Dow before the NASDAQ follows suit. This is simplistic, but the point is prescient and persistent: it would be the first time in history that the Dow makes a significant gain and the NASDAQ doesn't follow suit if the latter doesn't pick up.
In a presentation I gave earlier this year, I explained the process thus (with the accompanying slide):
The last two boxes, "Asset-backed securities" and "Intellectual property" represent equity, the other boxes are their own suigeneric investment catagories. The red arrows represent large-scale and sudden capital departure, wheras the blue arrows represent a timely and more rational movement of capital. Post-2003, the departure of speculative capital in real estate to the equity markets has been a capital transfer that is in part responsible for the growth in the charts above. The most serious stage in the capital markets in terms of capital departure however is represented in the smaller red arrow, where speculative investors leave commodity speculation in order to pursue higher returns in the equity markets. For some time, as the illustration shows, speculators have been toying with commodity speculation supported by a "safety net" of bond-weighted (usually government and AAA) investments.
This is where hedge funds have so dramatically changed the investment platform. Because they are inextricably and comparitively performance-based, once one hedge fund leaps into the equity markets and shows gains, the rest tend to follow. But why pursue equities rather than commodities? Simply because once speculators have realised gains on a base commodity, the next obvious investment is in companies which are benefiting from the rise in these commodity prices. In investing in these companies, they are assuming more risk, naturally, but there's also a higher potential upside: just look at the comparison of the increase in the price of oil and the increases in the prices of oil companies. While oil has showed around 100% rise in price, many oil companies have shown returns of four or five, or in some cases, as much as fifteen times that.
The reason technology is so popular for venture capitalists is that returns are high relative to risk. Technology is certainly risky, but it's not a volatile business with absolutely unpredictable returns, and the market rewards the sector with generally high valuations as a result. From this model, there is certainly an indication that technology is returning slowly to the forefront of the investment world, and that at some point there will be a significant influx of investment towards the sector.
… the markets suddenly converged in mid-June. Except for a few strays, (there's) a pretty strong positive correlation (between capital exists in commodities and capital introduction into paper). This tells us that money was coming out of hard assets like gold and into paper assets.
And there have been tech stocks roaring their way through the past 18 months. Akamai is one such company. Google is another. The latter's performance is worth considering for a moment. Trading at 473.99 at the time of writing, having beaten Wall Street's expectation on Q3 earnings hansomely only a week ago, it's worth putting under the microscope. This is a company which made a 90% jump in Q3 earnings on the year to $733.4 million, and a revenue increase of 70% to $2.69 billion. While that sounds impressive, the company blew $1.65 billion of those dollars on Youtube, and unknown and untested brand only weeks ago. That's another six month's record earnings at the same level to make the acquisition profitable in absolute terms, without dividends, and without re-investment in its own business. And that's if the concept succeeds. NewsCorp bought MySpace on even more tenuous terms less than three months ago.
All this financing action looks very much like a replay of 1995/6, when Netscape and Yahoo! stacked up one-billion dollar plus IPO prices, except that's it happening in the form of trade sales rather than IPO's. That's predicatble enough. The tech bubble of the 1990's may not have endured, but the impression that the internet is a growth and medium catalyst for hundreds of industries didn't lose any lustre.
My guess is, despite Google's precarious revenue model, the stock spikes $500 before the year end, and a few more 'social networking' sites start charging precarious valuations based on their own one year busines models. That's one billion dollars for one year of relative growth! And when these companies find they can't attract their corporate trade-buyers, the next logical thing is to find VCs looking to cast off their gains in the retail market. Or the VCs already financing this stuff will start to get bored with the lack of liquidity generally available in a trade sale. Or they'll just look for higher gains, from greater fools. Ridiculous or not, it's the trend of the market.
Last time round the argument was that rates had so far to fall that it couldn't possibly be a bubble. This time round the same argument is construable with commodity prices and lack of inflation. Whichever way you see, if you want to argue a five-year bull, the stats are there to make it believable, at least for a cyclical five-year term.
Let the games begin.