Wall Street Plays a Risky Game, Again

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Wall StreetA month and a half into the new year, all's well on the stock markets. Through the end of last week, the Dow Jones Industrial Average (DJI) had:
  • 19 "up" days.
  • Only 14 "down" days.
  • Overall posted a 6% positive return for the year.
Taking note of the Dow's progress, The Wall Street Journal recently called its performance "eerie ... calm ... too quiet." Indeed, if things keep going at this rate, we're on track for the stock markets to gain more than 50% this year. Dow 18,000, anyone?

Irrational Exuberance: Part 2

That sounds like a crazy number -- even reminiscent of Alan Greenspan's famed "irrational exuberance" comments, back before the Internet Bubble burst in 2000. But up on Wall Street itself, the stock market's steady gains have a lot of folks getting, well, downright exuberant.

At investment banker Brown Brothers Harriman, for example, the stock eggheads are already busy counting chickens. After coming into 2012 with fears of Europe on their minds, BBH says that "the decline in market volatility" has them feeling confident that it's time to take a more "aggressive" approach to the market.

"We had been focused on more traditional 'quality' metrics, but now [that] volatility's come down ... we no longer see strong evidence to support those factors outperforming." Dumping its investments in companies with modest debt and conservative balance sheets, BBH is instead pursuing faster gains in "more economically sensitive companies, such as technology and retail stocks."

But is that really wise? If the smart folks up on Wall Street think it's safe to seek out riskier stocks because the Dow's going up, should you follow their lead?

Earth to Wall Street: Are You Out of Your Mind?

"Dow 18,000" may sound like an attractive number, but here are a few data points for you to think about before buying into Wall Street's flight to high-flying tech and retail stocks.

The Dow Jones has never reached a value of 18,000 points before. Literally. Never. In fact, the highest the Dow has ever gone is 14,093, an apex hit on Oct. 8, 2007.

Historically, the Dow has averaged closer to a 10.5% annual return over long periods of time. Therefore, if 2012 is anywhere close to an "average" year, we've basically captured more than half the year's gains already, in just the first month and a half.

Valued against the profits that companies have earned over the past 10 years, the stock market is arguably already overvalued. If the average ratio of prices to trailing 10-year inflation-adjusted profits has been 18.7 for the past six decades, our current valuation of 22.3 suggests the stock market is already overpriced by close to 20%.

What's more, even stock market bulls who point to "trailing" year profits as the right P/E ratio to value, and call the market cheap at 15.5 times earnings, still say the stock market is only undervalued by 15% -- not 50%.

Storm Clouds on the Horizon

All of this suggests that the strong gains on the Dow that we've seen so far this year almost certainly won't continue through the rest of this year. When you consider how few gains remain to be had, shifting from safe investments in companies with low debt and sound balance sheets, and instead buying flighty retail and tech stocks, seems the height of madness.

All the more so when you consider the multitude of risks on the horizon, any one of which could shock investors out of their complacency, and undo all the gains we've enjoyed so far:
  • Europe hasn't come close to fixing its government debt mess. (Don't smirk, we haven't either.)
  • Iran's threatening to blow up oil tankers in the Persian Gulf, an event that would shock the oil markets and send gasoline prices soaring (and our economy tumbling).
And these are only the risks that we know about -- the known unknowns. They don't take into account any unknown unknowns circling out there like black swans, waiting to alight.

Wall Street may not want to think about all this. You should. As Sgt. Esterhaus might say: "Hey, let's be careful out there."


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24 Comments

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Wayne Bradshaw

Gucci sent their fall/winter 2012/2013 collection down the Milan Fashion Week runway today and it featured a much darker, more gothic and vampire-like color palette than what was shown by the iconic design house for fall 2011. One year ago Gucci Outlet showed bright colors and blocked them together, helping to explode the current color blocking trend. For fall 2012, Gucci moved away from the trend they started and let black rule the runway.

May 06 2012 at 12:04 AM Report abuse rate up rate down Reply
Dodger300

"Historically, the Dow has averaged closer to a 10.5% annual return over long periods of time. Therefore, if 2012 is anywhere close to an "average" year, we've basically captured more than half the year's gains already, in just the first month and a half."

Of course, I don't know what the market will do. But to speculate that the market is in anyway influenced by the "average" gain of 10.5% is truly naive and foolish. Markets don't work that way.

Some years the market goes up a lot, and some years it goes down a lot. Using such an statistical average is akin to saying that a man drowned in a river that was an average of two feet deep, when he drowned in a 20 foot channel.

I expected better from the Motley Fool!

March 25 2012 at 4:03 AM Report abuse rate up rate down Reply
bobbsafe

It is amazing how "out of touch" Wall Street is with real conditions. The SAME conditions are her that caused the crash 3 years ago - housing, jobs, overleveraged credit, etc. - yet according to Wall Street "traders" all is gleeful again.
40 years ago who would think the stock market would become a day trading gambling haven for hedge fund managers to sell Millions of dollars of equities evfery few seconds.
I would like to see a slow steady improvement - based on reality rather than this "if I can wear a suit I deserve to make money" thing we have now.

February 23 2012 at 3:05 PM Report abuse rate up rate down Reply
bobbsafe

It is amazing how "out of touch" Wall Street is with real conditions. The SAME conditions are her that caused the crash 3 years ago - housing, jobs, overleveraged credit, etc. - yet according to Wall Street "traders" all is gleeful again.
40 years ago who would think the stock market would become a day trading gambling haven for hedge fund managers to sell Millions of dollars of equities evfery few seconds.
I would like to see a slow steady improvement - based on reality rather than this "if I can wear a suit I deserve to make money" thing we have now.

February 23 2012 at 3:03 PM Report abuse rate up rate down Reply
Karl Hammerle

funny money for gullible people to panic about losing if the market drops. Remember:

1. buy low, sell high

2. You have not gained or lost anything until you sell.

February 22 2012 at 4:31 PM Report abuse +1 rate up rate down Reply
Karl Hammerle

funny money for gullible people to panic about losing if the market drops. Remember:

1. buy low, sell high

2. You have not gained or lost anything until you sell.

These two simple rules will help you remain sane as the market fluctuates up and down.

February 22 2012 at 4:29 PM Report abuse rate up rate down Reply
thefacts22

I know wall street,they are sales people,and they have been doing real bad for 3years,it is now like a bottle of soda under the sun,ready to explode,and in the process lie to themselves and "talk"many investors into risking more money,that in my opinion they will loose.Our fundamentals are not good,"the USA debt is unsustainable"and there is no way that printing money or "cooking"vital statistics will work in the long or short run.The European debt is the same,they simply lack the productivity,to come out of the hole any time soon,it will take decades,to fix.Most 401 k plans are far from recovery,any more damage could be fatal.For private investors my advise is in and out,short time investment and sell

February 22 2012 at 4:10 PM Report abuse +1 rate up rate down Reply
josephautomotive

just remember, tank the economy again, we wont be demanding simply more taxes from you, we will be demanding your heads on a pike

February 22 2012 at 3:35 PM Report abuse +3 rate up rate down Reply
2 replies to josephautomotive's comment
BLONDIE & GRUMPY

Amen, Brother and Semper Fi...If we got one-tenth of what was promised to us in these
acceptance speeches there wouldn't be any inducement to go
to heaven. ~Will Rogers

February 22 2012 at 7:16 PM Report abuse +1 rate up rate down Reply
BLONDIE & GRUMPY

Amen, Brother and Semper Fi!!!

February 22 2012 at 7:17 PM Report abuse rate up rate down Reply
invmartyc

Gordon Geeko is back up to his old tricks! Thank you GOP!

February 22 2012 at 1:46 PM Report abuse -3 rate up rate down Reply
wlh1923

Bigger question is why do wall street traders wear those silly smocks?

February 22 2012 at 1:16 PM Report abuse +1 rate up rate down Reply