Special to the Globe and Mail
Published December 13, 2013

By Tom Bradley

A long stock market run goes through many phases. There’s a healthy debate going on right now as to where this one is at – does it have further to go, or is it over? In assessing where we are, it’s useful to look back at how things unfolded over the last four and a half years, and understand why markets have gone up so much.

I’m going to look at it through three lenses – fundamentals (the outlook for profits and dividends); valuation (what we’re paying for those profits and dividends) and investor sentiment (how bullish or bearish investors are).

When this bull market started on March 9, 2009, the fundamentals didn’t look very good. The banks were teetering, a recession was imminent and the outlook for earnings was poor to say the least.

In hindsight, it was as good a starting point for a bull market you’ll ever see. The necessary requirements were all there – a poor short-term outlook, rock-bottom price to earnings multiples (P/Es), forced selling from margin accounts and liquidity-strained pensions funds, and a feeling that we’ll never make a decent return in the stock market again.

The first up year was triggered by a trembling acceptance that the banks would survive and fuelled by valuations recovering from “the-world-is-ending” to “ridiculously cheap” levels. The fundamentals in 2009 still weren’t very good and, as a result, the rally was characterized by disbelief and confusion. But as Sir John Templeton famously said, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”

Over the past four years, the economy was stable enough for companies to grow their earnings, but there was still lots to worry about. European countries took turns going through crisis, U.S. deficits were enormous, and the job of fixing things fell on the central bankers, who pushed us to addiction on “temporary” monetary stimulation.

In my view, this “Red Bull” cycle was not driven by fundamental improvement as much as valuation change. Most companies saw their earnings grow, but rising P/Es (supported by historically low interest rates) were the biggest factor.

I’ll illustrate this point with a simple example. Let’s say that in early 2009, Company A was earning $1 per share and trading at $10 (a 10 multiple). Even with no improvement in earnings initially, the P/E recovered to a still modest 13 times as the stock went up 30 per cent. In the next year or so, earnings expectations started to rise and the stock moved back to its normal multiple of 15. By then, it was trading in the high teens. With a further improvement in earnings, a couple of dividend increases and a robust enough market to push the P/E to 17 times, the stock had doubled in three years.

So where are we today? Well, fundamentals are still mixed. A Red Bull hangover is looming, which means GDP growth will likely be modest and profit increases harder to come by. The year-over-year comparisons are no longer easy.

Valuations are now above their historical averages and are increasingly dependent on low interest rates. In other words, if rates stay where they are, multiples are okay, but if they rise, there’s not a lot of cushion.

Could stock markets go up another 20 per cent? Absolutely. If rates stay low, dividend yields will be competitive and the momentum may continue. The cycle may also get a boost from some of the usual hallmarks of a bull market, namely an active merger market and a flood of new structured products linked to the stock market. So far, it’s been quiet on both fronts.

But, a 10- to 20-per-cent retrenchment shouldn’t surprise us either because two of the three factors I’ve reviewed are getting stretched (valuation and sentiment).

Bottom line: It’s time to be patient. There are no fat pitches, slam dunks or gimmes that I can find. Stocks still offer the highest potential reward over the next five years, but the environment doesn’t set up for another trifecta with earnings, multiples and sentiment going up in unison.

It’s a time to stick to your plan and make sure your stock weighting is no higher than the long-term target. While the bull versus bubble debate rages on, rebalancing is the order of the day.