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Beware of share market records

“Dow 16,000. You beauty.” That’s the refrain among the investment commentariat.

No less than The Wall Street Journal sent its subscribers an email to inform them that the Dow had closed above 16,000 points for the first time.

Which is great, right? Maybe…

A wealth-creation juggernaut

We all want to make money. And a rising share market is a great way to do it. Indeed, Australian shares have turned a hypothetical $10,000 investment into $270,000 over the last 30 years, according to index fund manager Vanguard.

In doing so, the ASX outperformed international shares, bonds and cash, and left inflation in the dust.

And for investors who bore the brunt of the GFC, a recovery back toward the levels of 2007 is welcome, especially with many tempted to abandon the roller-coaster of shares for the relative – if under-performing – safety of cash in the bank.

It’s also always been the case that the market regularly sets new records as economic growth, rising living standards and innovation propel our economy – and the best businesses listed on the ASX – strongly upwards.

But that path is never smooth, nor straight. The ASX, like the world’s stock markets, experiences booms and busts, with periods of exuberance and pessimism exacerbating changes in the economy.

From boom to bust and back again

In all of the talk about the US sub-prime crisis and the resultant GFC, very little attention is paid to the fact that the ASX was very expensive – relative to earnings – in 2007, just before the GFC arrived.

As a result, many investors – and commentators – talk about a new Dow record as if we’re recovering from deep levels of undervaluation in 2008 and 2009 back to (and above) the ‘fair’ value levels of 2007. They never use those words, of course, but that’s the reality.

But the ASX in 2007 wasn’t at fair value. It mightn’t have been at extreme levels of valuation, but it was expensive. According to S&P Capital IQ, the ASX 200 sold for a peak of 26.7 times normalised earnings in mid-2007.

Now, in the meantime, profits have fallen and then recovered – as have share prices. But it’s future profits that matter to valuations – the past might be a guide, but it’s not enough.  So while it’s tempting to cheer share price increases, that enjoyment will be short-lived – and pointless – if prices crater soon after.

And before you imagine you’ll be the rare investor who can regularly pick market tops and market bottoms, let me burst your bubble. You’re not, as <many investors discover> (http://www.fool.com.au/2013/11/19/your-term-deposits-aint-gonna-make-you-rich/).

Price is what you pay, value is what you get

Rather than cheering Dow 16,000, or even the share prices of the companies they own, investors should be focussing on the businesses themselves.

As Motley Fool Share Advisor members know, we like rising share prices, but we like them much more when it’s a previously undervalued company whose shares are being propelled higher by rising profits.

There’s nothing more certain than that share prices will follow profits over time. Not immediately, perhaps. Maybe not even in the medium term. But in the fullness of time, investors’ returns are highly correlated with the growth in profits of the companies they own – as long as one other important criterion is present: A reasonable price. If you start by paying too much, you’ll need some good profit growth just to stand still.

Just ask Microsoft shareholders who bought shares in 1999. In its 2000 financial year, Microsoft earned profits of US$9.4 billion. In the most recent 12 months, that profit number was US$22.6 billion. That’s a pretty good (if not spectacular) compound growth of 7% per year. And the share price? Down by more than one third. The culprit wasn’t the company – it was the fact that in 1999, the shares were priced at a crazy 87 times earnings, according to Capital IQ.

Foolish takeaway

So by all means, feel free to celebrate Dow 16,000, or ASX 5,500 (when it gets there!). But don’t get too carried away. The market giveth and the market can taketh away – and if you’re still saving for retirement, higher prices mean you’re getting less for each dollar of reinvested dividends.

And remember, a crash can be a great time to go shopping for bargains!

The Australian Financial Review says "good quality Australian shares that have a long history of paying dividends are a real alternative to a term deposit." Get "3 Stocks for the Great Dividend Boom" in our special FREE report. Click here now to find out the names, stock symbols, and full research for our three favourite income ideas, all completely free!

Scott Phillips is a Motley Fool  investment advisor. 

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