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Dow Hits Record Highs ~ Are Stock Markets Due a Correction?

Much has been made in recent days of the record breaking rise of the Dow Jones and many bulls in the market are predicting further rises. These record breaking rises seem remarkable when you consider the back drop of the financial stalemate up on Capitol Hill and the fragility that remains prevalent in the worldwide economy. So are these stock market gains sustainable or could a market correction be on the horizon?

Why Are Markets So High?

As we’ve mentioned the rise of the Dow Jones to record levels almost flies in the face of conventional wisdom when you consider the backdrop, so why are markets so high? Much of the credit for this can be attributed to the Federal Reserve and quantitative easing.

The Federal Reserve has been pumping massive amounts of money into the economy through bond buying programs known as quantitative easing ever since the financial crisis gathered pace back in 2008. Those of you who invest in or watch the stock markets on a regular basis will have noticed that every time the Federal Reserve has announced a new round of quantitative easing (QE1, QE2 etc.) it has always been followed by a rally in the markets. Why?

In theory quantitative easing puts more money into everybody’s pocket. Quantitative easing provides banks with more money to lend to people who are looking for loans and other credit, this then gives businesses and households more money to spend and in turn boosts company profits, as a result the share prices of those companies rise.

Whether this money has been evenly distributed or not is debatable. What quantitative easing has achieved over the past few years however is to stop the economy from falling off a cliff, what it doesn’t seem to have accomplished yet is the overall goal of bringing the economy back to a point where it can stand on its own two feet and generate sustainable growth.

This is where the alarm bells start ringing and we have to wonder if a stock market correction is on the horizon.

Are we in a bubble?

Think back to the boom years. Credit was flowing freely, overly so in fact. House prices were booming, retailers were thriving, sovereign debt and sovereign credit ratings weren’t an issue and consumer spending power had never been greater. How does that compare to today?

The economic outlook today isn’t anywhere near as promising as it was in those credit driven years. Yet today we see stock markets at record levels, does that make any sense?

Through quantitative easing central banks have been trying to replenish the money that had to be written off during the financial crisis so that banks can continue to lend. Also low interest rates were introduced to stop many households from going under and these low rates also increased the spending power of many homeowners. To some extent these stimulus measures have succeeded but only it seems on a temporary basis, they don’t seem to have created a sustainable footing for future growth.

We have to ask then ‘Are the current market highs here to stay or are they a simply a giant bubble waiting to burst?’

QE has its Limits

A long, long time ago when I was a vibrant youth I was sent on a work experience placement at a building firm and was set the task of mixing the mortar. Now, it was the middle of summer so it was pretty hot and after returning from my lunch hour I found that my mortar mix had almost completely dried out. I was just getting ready to throw the mix out and start a new one when one of the builders on site stopped me in my tracks. He explained that I might be able to revive the mix by adding a little water.

Now you’re probably not reading this post because you’re interested in building but this simple illustration is designed to explain what the Federal Reserve has been trying to achieve through quantitative easing and why it has its limits.

Anyway, I started to add a little water to the mix and sure enough it became workable. Later in the day though the mix began to dry out again, more quickly in fact because the more times a mix needs to be revived, the less workable it becomes. Eventually adding water to the mix lost its effectiveness and I had no choice but to throw it out and start again.

This is similar to the effect of quantitative easing on the economy. Adding a little liquidity into a struggling economy can sometimes be just what is needed to revive it and allow it to continue functioning. If QE doesn’t work the first time and the economy dries up again another injection of liquidity might buy you a little more time for things to pick up. Eventually though adding more liquidity into the economy or ‘mix’ becomes ineffective and you have no choice but to head down a new path.

Life after Stimulus

Before jumping on with the market bulls and taking a ride on the current stock market gravy train, take a few moments to consider what might happen to the economy and also the stock market if stimulus measures start to lose their effect. When stock markets are on a bullish or bearish run they tend to overshoot in the direction which they are travelling, my guess is that markets may move a little higher yet but stimulus measures can’t go on forever and the longer they do go on for, the less effect they will have. Let’s just hope the economy doesn’t become so unworkable that we have no choice but to throw it out and start again.

What Do You Think? Are Record High’s Here To Stay Or Are We In A Huge Bubble?

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10 Responses to Dow Hits Record Highs ~ Are Stock Markets Due a Correction?

  1. Jose says:

    This market definitely has me concerned. I’m liking the new highs but am worried about the correction which will come at some point. I’m taking a defensive posture at this point, pulling a few gains off the table and putting stops (trailing) on positions that I wouldn’t mind taking the profit out of anyway. Ideally, i should have a decent sideline of cash to take advantage of corrections when they occur. Not a large amount, but enough to pick up on some good buys that I’m tracking anyway.
    Jose recently posted..A Coupon for the Man (or Lady) CaveMy Profile

  2. I don’t think that we’re in some sort of bubble, for many of the reasons you mentioned. I also don’t know if the highs are high to stay or not. I think we may have some sort of correction, but not the doom and gloom that some might think. Of course, I could be completely wrong and we could see Dow 7000. I am enjoying the gains and may pull some off the table soon, but am continuing to stay the normal course I have set.
    John S @ Frugal Rules recently posted..Frugal Friday: Blog Posts That Ruled This Week, Top Ten EditionMy Profile

  3. The market is such a pain right now. QE will lose its effectiveness, but hopefully the economy will pick back up. I don’t think the market will continue with gains, but I don’t think we are in a bubble. Now, how much of a correction is the next issue.
    Grayson @ Debt Roundup recently posted..When DIY Plumbing Works Out In Your FavorMy Profile

  4. I also feel that we are going to correct sometime soon. I feel we could test 1,600 but ultimately that will fail and we will correct 5%-10%. I think the average investor is finally starting to gain confidence so that could help out.
    Sean @ One Smart Dollar recently posted..When to DIY and When to Hire OutMy Profile

  5. CF says:

    I’ve been noticing my stocks have all been high lately. I’ve been kind of stuck on what to do about it – I have money to buy, but don’t like the thought of buying while things are so high. At the same time, I’m not making anything at all with the money just sitting in my account. :S
    CF recently posted..Updates: March 3 -9My Profile

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