Markets Close at Record High: How Likely Is Dow 20,000?

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Both the Dow Jones Industrial Average and the S&P 500 closed at all time highs on Monday. The Dow climbed 0.68 percent to close at 16,695.47 after touching an intraday high of 16,704.84. The S&P 500 climbed 0.97 percent to 1,896.65 after touching an intraday high of 1,897.13. The Nasdaq, not to be forgotten, climbed 1.77 percent to 4,143.86, but is still down this year to date.

The S&P 500, though, is up 0.86 percent — anemic compared to 2013′s frenetic rally and reflective of a sometimes melancholy and always skeptical investor. By the last quarter of 2013 it was all but determined that 2014 would be underwhelming for equities, which is the narrative that appears to be panning out. It’s convenient to justify the price action by citing monetary policy, which, although tightening, is still highly  accomodative. The target federal funds rate, a benchmark against which market rates on interest are calibrated, remains at the zero bound.

Moreover, Federal Reserve Chair Janet Yellen expects the rate to stay low for the foreseeable future. “In particular,” she told the Congressional Joint Economic Committee in May, “we anticipate that even after employment and inflation are near mandate-consistent levels, economic and financial conditions may, for some time, warrant keeping the target federal funds rate below levels that the Committee views as normal in the longer run.”

Historically low interest rates during the recovery have been manna from heaven (the Fed) for equities, and the expectation that rates will remain low is a large part of current market sentiment. Investors, as always, seem eager to chase gains, but many appear skeptical of the foundation on which fresh market highs are built on and may just be interested in letting equities sit, as they generally have since the beginning of the year.

According to the AAII Sentiment Survey, bullish sentiment among investors declined 1.4 percentage points to 28.3 percent and bearish sentiment declined 0.8 percentage points to 28.7 percent for the week ended March 7 — most investors, 43 percent of the survey sample, are neutral. That is, most investors don’t expect the market to do anything or are simply unsure if the headwinds are stronger than the tailwinds. The level of neutral sentiment is well above the long term average of 30.5 percent, while bullish sentiment is well below the long term average of 39.0 percent. Bearish sentiment is only slightly below its long term average of 30.5 percent.

The low rate environment also seems to have made investors and traders a little more sensitive to value than normal. The value debate has been especially loud in the Internet and biopharmaceutical sectors, where IPO activity has been high. However, the IPO market appears to be cooling off and bullish sentiment along with it.

Speaking to Inc., Renaissance Capital Principal Kathleen Smith pointed out that tech IPOs in 2014 have severely underperformed every other sector. Some big ticket names like Twitter (NYSE:TWTR), which rocked high valuation at its IPO and an even higher valuation a few months later, have also cooled off.

As a whole, though, the S&P 500 is looking a little warm (call it Yellow alert.) The index current trades at a trailing twelve-month price-to-earnings ratio of nearly 19, which compares against a mean of 15.51 and a median of 14.54. Even the Shiller P/E, or the PE10, which is based on average inflation-adjusted earnings of a 10-year horizon, is elevated at 25.6, which compares against a mean of 16.52 and a median of 15.91. The Dow is trading at a trailing PE of 16.35.

With valuation and sentiment in mind, it doesn’t seem like there should be a lot of steam left in the market. But there is the monetary tail wind and the very real and very human tendency to chase growth. This could mean higher equity prices as investors swallow concerns about valuation and pay the premium. Or, a healthier alternative, the market locates previously unidentified undervalued companies, and brings them up to par.

In order for the Dow to reach 20,000, it would have to climb nearly 20 percent from its closing price on Monday. With the second-quarter underway and sentiment as soft as it is, reaching this benchmark seems like a fiction.

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