Last year (2013), the Dow Jones Industrial Average rose 32.4%. Sounds like a phenomenal increase, doesn’t it. A plus 32% increase is, indeed, an impressive increase. However, in this case, a little more analysis is warranted. Why did the market increase so much? The following data are from Standard & Poor’s and J.P. Morgan Asset Management Guide to the Markets-US (as of 12/31/2013).
Price/Earnings Multiple Expansion
Of the 32.4% increase, 18.4% (or 57% of the total increase) was due to an expansion in the price/earnings multiple. Investors buy stock in anticipation of a future earnings stream from the issuing company. The price to earnings ratio represents “how many times” the company’s earnings that investors are willing to pay for the stock. In 2013, that price/earnings multiple expanded from approximately 14 times to over 16 times. Quantitative Easing (the Fed’s buying of Treasuries and mortgage backed securities) figures prominently in this increase; the Fed’s buying drove interest rates so low that stock became a more viable investment (even with the increased risk).
Dividends accounted for 2.8% of the 32.4% gain (9% of the total increase).
Corporate earnings accounted for 11.2% (or 34%) of the total 32.4% increase in 2013. What about those earnings? How were they obtained? In many cases, earnings were driven by expense reduction, not increased revenues. A company can do only a finite amount of expense reduction and still remain in business.
What Does This Mean?
Given the above, how likely are we to continue such growth? Ninety one percent of the gain was driven by factors that may not be in play going forward. At Paragon Financial Advisors we believe that the equity markets offer significant long term benefits; however, the ride from “here to there” can be bumpy. Come visit with us about ways to try to manage the risk in reaching your long term financial goals. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.