Dollars and Sense: Christmas isn't over on Wall Street

Christmas rally continues. Santa Claus was good to the markets this year. Friday was the seventh straight day of gains for the Dow, which closed above 18,000 for the first time ever on Tuesday. The S&P 500 set 50 record closes this year, while the Dow set 38.

Overvalued? So is this irrational exuberance, or do economic fundamentals support these prices? That’s become a relevant question again. On the one hand, the economy is doing better. We got news last week, for example, that during the third quarter the economy grew at a sizzling 5 percent annual rate. That’s the fastest growth in more than a decade. And the jobs picture keeps getting better, too. Weekly jobless claims fell for the fourth straight week, an indication of steady improvement in the job market. The number of new claims for unemployment benefits dropped 9,000 to 280,000. That indicates solid job growth and was significantly better than economists’ expectations.

Price-to-earnings ratio. All that sounds good. But while no one was looking, the price-to-earnings ratio for the S&P 500 has crept over 20. The historical mean is around 15.53. If you know anything about statistics, you know that at some point we’ll get what mathematicians call a regression to the mean. In other words, stocks will have to fall, or earnings will have to rise. In both cases, those changes will have to be significant to move the PE ratio back to normal. The upcoming earnings season, beginning in the second week of January, will be very important. If earnings are not significantly higher, we could see a significant stock market correction.

The Sony effect. Lots of people are asking if all the drama surrounding the movie The Interview will have a long-term effect on Sony and on the markets generally. It will, but it will be months before we know exactly what the real impact will be. The computer hackers did real damage to Sony, with the company’s share price dropping because of the damage to its systems and its reputation. But on the other hand, insurance likely will mitigate some of those losses. Then there’s the movie itself, which had been projected to do more than $100-million at the box office and now will likely do much less. The real issue here is just how vulnerable all companies are to cyber-attack and blackmail by hackers. My guess is that this episode will be create a boom for cyber-security consultants that could last for years.

The week ahead. It’s going to be a very light week for government reports, or reports from just about everyone else. New Year’s Eve and New Year’s Day cut the week in half, so lots of folk are taking all or most of the week off. That said, it will be interesting to watch the flow of cash in the weeks ahead. January often is a good month for the markets. It’s called “The January Effect.” It’s a time when investors, for a variety of technical and other reasons, tend to move more fully into the equities market. That has a tendency to drive the markets up overall. But if the markets stay flat or even trend downward, that could be the beginnings of this regression to the mean that we’re eventually going to have to see.