As previously published on In Business Wisconsin December 19, 2013 issue

By Sara J. Walker, CFA, is a senior vice president and investment officer for Associated Investment Management

According to Newton’s first law of motion, uniform motion describes an object continuing on its path until an outlier event throws the object off course. This law, while typically applied to physics, can also be used to discuss the current U.S. stock market.

The Dow Jones Industrial Average is making new highs, and the Nasdaq composite broke through 4,000 for the first time in 14 years. In addition, the S&P 500 index is up over 25% on a year-to-date basis. Numbers like these might lead one to expect us to be warning about a stock-market bubble, but we’re not quite there … yet. It’s clear that U.S. stocks are not the bargains they once were, but the clamor to own them is not quite over the top.

Most investors burned by the last stock-market crash still remember the pain. Although many investors are once again excited about stocks, we still detect a certain reluctance in the air. But not to worry, that’s a good thing, as it’s typically when all caution is thrown to the wind that stocks move into bubble territory.

So what do we mean by a “bubble”? In stock-market parlance, the word refers to a time when investor giddiness stretches stock prices to higher highs. Prices move far beyond levels that reflect a fair assessment of company earnings. Similar to an actual bubble, an investment bubble just keeps getting bigger and bigger until it bursts.

In addition to seeing Newton’s law at work, we see support coming from the U.S. economy. Conditions are continuing to improve. Headwinds such as political bickering and geopolitical tension have been regularly surmounted. Risks to this optimism do exist, but our economic foundation continues to be strong.

The driving reason behind our optimism is the U.S. consumer. House values are up, and according to the recent Case-Shiller 20-city home price index, there has been a +13.3% year-over-year gain to a five-year high. Combine this recovery with rising stock prices and you have consumer net worth at all-time highs of approximately $75 trillion. This boost has been largely driven by the U.S. Federal Reserve’s quest to boost asset prices through its quantitative easing program.

Believe it or not, consumer balance sheets have also strengthened. The debt-service ratio is at a historic low of less than 10%, and credit card delinquency rates plunged 5.3% in the third quarter for the largest decline in over five years. In another nod to the Fed, mortgage interest payments have declined about 8% from year-ago levels in a further boost to monthly household cash flow. And this cash flow is being spent.

Recent retail sales reflected the third-best gain of the year right in the face of the U.S. government shutdown. On a volume basis, retail sales are trending at about a +5% annualized pace. Restaurant activity, one of the most discretionary components of retail sales, posted a +4.4% annualized pace of growth in October, which we believe bodes well for the holiday season. Stock-market investors have taken note of this willingness to spend by driving stocks in the consumer discretionary sector up about 37% on a year-to-date basis.

Lastly, we are finally beginning to see an improvement in consumer incomes. Sluggish income growth has been the albatross around this recovery’s neck, but that appears to be changing. Recent reports show annualized average hourly earnings growth for production and nonsupervisory employees at +2.2%, compared to the prior 12-month period that registered only a +1.3% annualized gain. One partial explanation for this improvement relates to the renaissance in the U.S. energy sector. Job growth in this sector is up almost 6% versus last year. As a percent of total U.S. employment, the energy sector now accounts for its highest share in over 20 years.

Animal spirits are awakening, and this drives spending growth, which ultimately drives job growth. Yes, even that final challenge to this recovery is loosening its grip. October’s job growth, at 203,000, was much better than expected. Furthermore, several regional Federal Reserve indexes are registering improvement. For example, the Dallas Fed reported spikes in business hiring plans and wage intentions over the next six months, and the Kansas City and Richmond Feds both reported upside surprises to their manufacturing indexes with six-month wage intentions at two-and-one-half-year highs.

We are optimistic about the U.S. economy and see reason to apply Newton’s Law to our stock-market outlook. Of course, there are plenty of opportunities for outlier events to knock things off course, but a carefully constructed, well-diversified investment portfolio continues to be the best answer to that risk.