Dow at 15,000: What the stock market is telling us

As Wall Street posts a new record, experts decode its message about the state of the economy – and whether it's too late to invest.

Cover Story

A year into the worst economic downturn since the Great Depression, James Angel went all in with stocks – in fact, more than all in. In January 2009, the finance professor at Georgetown University bought leveraged exchange-traded funds, which allowed him to borrow money so he could own more stock. He was convinced the market was nearing its nadir. He thought it was a perfect time to invest.

The market was cruel, at first. Already down more than 40 percent since 2007, stocks sank another 25 percent between January and March – enough that Mr. Angel needed to put in more money to keep his borrowing in line with the declining value of his holdings.

"I didn't realize I was close to a margin call," he recalls. "I was too busy teaching."

His broker sold some of his holdings before Angel's portfolio slipped to the point where he couldn't cover all his losses. Having inadvertently sold stocks when the market was so low, he walked into class that morning and announced to his students, with the dark humor of someone who knew he had probably liquidated assets at precisely the wrong moment: "This is the bottom."

And so it was. On March 9, the Standard & Poor's 500 index closed at 676.53 – a 12-year low. Since then, the market has been downright cocksure. The S&P 500 index is up some 135 percent – the fifth-strongest bull market since 1929 – giving Angel and others who invested at the right time a very healthy return. (Angel is still fully invested in stocks.)

With the S&P hitting record highs this spring, the market has erased all the trauma and financial turmoil of the past six years. And that poses a fundamental question for Americans from Long Island to Los Angeles. What is the market telling us?

Five years after one of the worst global downturns of the past century, after all, not that much has changed. Europe remains precarious financially, not to mention politically. The United States is mired in a period of slow growth and corporate caution. Even indefatigable China seems to have lost economic momentum.

Yet something has changed. The US stock market – that barometer of crowdsourcing long before the term was invented – is back. And it's telling anyone who'll listen: The fears of 2009 were overblown; the financial and economic risks that loomed so large have receded a bit. Yet the market is also delivering a more sobering message: Stocks can prosper when the Federal Reserve shovels vast amounts of 0 percent cash into the economy.

Market optimists cling to the first message. Pessimists focus on the second and ask: What happens when the Fed ends its support? Is this another bubble waiting to burst?

Whichever message turns out to be nearer the truth will affect million of investors, from baby boomers to Millennials. It holds the key to whether the current bull market will keep going – and for how long – which, in turn, will shape an older generation's retirement accounts and a young generation's decisions about how much to trust the market as a future source of income.

"There's a disconnect," says Kenneth Polcari, director of floor operations for O'Neil Securities at the New York Stock Exchange and a CNBC contributor. "I walk around the town I live in and I still see storefronts that are empty. I still see people out of work.... When you talk to your next-door neighbor, he's frustrated because he can't understand why the market is doing so well."

Plenty of cautious investors share that frustration. In the wake of the financial crisis, many people stopped putting more money into stocks. A sizable minority – 22 percent, according to a recent Monitor/TIPP poll – pulled all or most of their money out. Of those who left the market, 66 percent said they were waiting to put their money back in and another 21 percent were not sure what they would do, according to the poll of 915 adults conducted March 25-30. Only 10 percent had reinvested in stocks.

But as Wall Street has set new highs, a rising number of investors are coming off the sidelines to put money back into equities. In the first quarter of this year, US equity mutual funds and exchange-traded funds saw a positive net influx of $52 billion, according to TrimTabs Investment Research, an independent research service based in Sausalito, Calif. That's the biggest quarterly inflow since the first quarter of 2004 and only the third positive quarter in the past four years.

But this time, individual investors are moving into stocks with more discipline. Of those in the TIPP poll who called themselves investors, typically those with more than $10,000 in individual stocks or mutual funds, 67 percent said they had "become less aggressive, emphasizing more conservative, higher-yielding stocks" and 58 percent were buying fewer individual stocks and relying more on mutual funds.

Richard Climie, a retired engineer in Phoenix, describes himself as a "recovering buy-and-hold addict." The buy-and-hold strategy worked well for stocks during the long bull markets of the 1980s and '90s. Investors could make money buying just about any stock.

But the bursting of the dot-com bubble in the early 2000s and especially the financial crisis near the end of the decade have caused many investors to reconsider their methods.

Mr. Climie closed all his "traditional" stock positions in early 2008 and is now actively trading options.

Options, which offer an investor the right to buy or sell a stock at a certain price, are easy to get in and out of and provide the flexibility to move from one market sector to another, says Climie, who is also vice president of the Phoenix chapter of the American Association of Individual Investors. The approach requires more sophistication than simply buying mutual funds – and can be risky – but that doesn't seem to bother today's investor.

"The only benefit of that whole [2007-09] period for investors is that it caused them all to take a closer look and get more involved in their finances," says Steve Quirk, senior vice president of TD Ameritrade's trader group, who is based in Chicago. "The retail client is far more savvy than they were in yesteryear."

One example is Ameritrade itself. Three years ago, some 9 percent of its retail investors' trades were derivatives, usually options. Now, derivatives make up almost 40 percent of their trades. "We have close to 80,000 people last year who traded their very first option with us," Mr. Quirk says.

Options allow shareholders to buy some price protection in big downturns. For example, those who bought Apple at $450 might buy the option (or right) to sell the stock at $375, thus limiting their losses to $75 a share if the stock plunges.

But options can also be used to boost returns when a stock is moving sideways. The Apple shareholder who bought at $450 and who likes the company's long-term prospects can sell the option to someone else to buy the stock at $525. That limits the investor's gains to $75 a share if the stock jumps, but that person can still make money if the stock price stays flat. This is the strategy that many Ameritrade customers are using.

Ameritrade's investor movement index, a relatively new behavioral measure of its 6 million individual investors, finds that they are carefully moving to take on more risk and have become far more bullish over the past nine months.

Some investors have no plans to get back into stocks, either because they believe they've missed the rally or don't believe it's real. "It would have been nice to have caught the market's rally," says Brian Hodgeman, an insurance agent from Cleves, Ohio, who largely exited the market in 2008. "But there's too much risk in the market, and I don't feel too badly that I didn't" jump back in. The collapse that occurred "in 2008 could happen again."

Other investors have reentered the market, like Richard Groen, who describes himself as "personally cautious." In mid-2008, the retired high school English teacher from Livonia, Mich., sold off more than half of his individual stock holdings. Once the market bottomed and rebounded by about 10 percent, he began reinvesting slowly. At first, he spread it across many stocks and funds. Then, about a year and a half ago, he started putting a special focus on real estate investment trusts. Soon, he plans to sell some of his riskier holdings, take his profits, and rebalance his portfolio "to make it safer."

In a way, the Federal Reserve is forcing Americans into stocks. With interest rates essentially at zero, Americans can't earn enough money from certificates of deposit to keep up with inflation. Bond prices, which move in the opposite direction of interest rates, have nowhere to go but down once the Fed allows interest rates to rise. That Fed support is proving to be a double-edged sword.

On the one hand, it's helping to calm fears that stocks will collapse. Retired investor Climie, for one, expects to "remain bullish as long as the Fed continues to flood the market with money." On the other hand, the Fed's involvement may be artificially boosting equities. Each time the central bank has signaled that it was ending its special intervention to lower interest rates, the market has plummeted, points out Mr. Polcari of O'Neil Securities. What happens when the Fed pulls out for good?

The different approaches investors take varies, to a large extent, by generation. When Heather Adams, a 20-something, was laid off from her job at a vocational-training college in Boston two years ago, she didn't panic – and she didn't give up on stocks. When she found a high school teaching job in Pasco County, Fla., she was able to convert her 401(k) retirement plan into a 403(b), the public sector equivalent, without penalty. She now has three retirement accounts: In addition to her 403(b), there's her own private Roth individual retirement account and a government pension plan that she's eligible for after her eighth year of teaching (she's now in her second). Like many Millennials, she has plenty of time to ride out future bear markets before she retires.

Baby boomers, however, do not. They're the investors who lost the most during the financial crisis and have the least amount of time to recoup their losses. Hit by the dot-com crash of the early 2000s as well as the financial crisis, they're unusually cautious. Yet the absence of a healthy return on traditional conservative assets, like bonds, is forcing them into riskier holdings.

"Our clients, baby boomers in particular, they're afraid of the market," says Scott Wren, senior equity strategist with Wells Fargo Advisors in St. Louis. "But they're afraid that they'll outlive their money in retirement, too."

What boomers decide to do will help determine the future course of the market. A new influx of money into stocks would tend to bid up prices. How much money people are holding onto is uncertain. "It's lots – trillions," says Mr. Wren. "But I question whether much of that money will ever come back into the market."

There are other potential sources of new cash for the market. Bondholders are expected to rotate out of bonds once the Fed allows interest rates to begin rising. So far, however, those anticipating a great cycle out of the financial instruments have been disappointed.

Foreign investors are also putting money into the US market. After falling by more than a quarter between 2007 and 2009, the value of US equities held by foreigners has rebounded and reached a new record of $4.2 trillion as of June 2012, according to the Treasury Department. With fresh concerns from Cyprus about government appropriation of large bank accounts in the eurozone, more money from Europe is thought to be flowing into the United States, says Polcari.

This isn't the first time the stock market has staged a big recovery and individual investors have been late to the upturn. After four years, this bull market looks enervated. But many analysts say stocks still have room to rise.

"We're in what we consider to be the fourth quarter of this bull market," says Patrick Hejlik, chief executive officer of Fourth Quadrant Asset Management, a wealth-management firm in Danville, Calif. "We think there's still some significant upside to the equity markets. Fourth-quarter bull markets can be tremendous periods."

Other analysts are even more optimistic. "I believe we're at the beginning stages of a bull market," says Christopher Zelesnick, senior managing director of Ziegler Wealth Management in Chicago. In his view, much of the market's run-up since 2009 was a snap back to normalcy and the bull market is really only 15 to 18 months old. With the Dow Jones Industrial Average having flirted with the new highs near 15000, "I think it will hit 20000 before it sees 10000."

But everyone recognizes that the market does not go up in a straight line and that pullbacks are inevitable. "One thing we know from history, it's going to be a wild ride," says Angel, the finance professor. "To paraphrase Harry Truman, if you can't stand the volatility, stay out of the market."

– Monitor Correspondent Margaret Price contributed to this story from New York.