Some say the stock market is getting long in the tooth. Valuations are high, especially in sectors like social media and biotech. A recent Wall Street Journal article reported that several prominent forecasters, who have long been predicting a coming bear market, have recently capitulated. This bull market has steadily marched higher (albeit with the occasional short decline) for more than five years.

Our title is not offering life advice that one should age cheerfully, but rather refers to the third part of the Sir John Templeton quote that we have referenced several times over the last five years. He said that “bull markets are born in pessimism, develop in skepticism, mature in optimism, and die in euphoria.” From the bottom in March 2009 through 2011, investors were pessimistic. Recall the “Grexit”, when the world thought Greece would default then exit the Euro or the US technical default in the summer of 2011 which resulted in the first credit rating downgrade from AAA since the advent of the modern system of credit ratings.

In 2012 and 2013, markets became skeptical. Unemployment stayed well above 6%, deflationary fears were rampant and yet stocks rose. This skepticism was still in evidence through mid-2013 when we experienced the “taper tantrum” and longer-term interest rates began to rise. In May of last year, the Federal Reserve first indicated that it would begin reducing Quantitative Easing (QE) and 10-year US Treasury note yields subsequently nearly doubled from 1.6% to 3.0% at year-end. Meanwhile, the stock market traded sideways for 90 days, then resumed its climb to a new high.

This year, skepticism has been waning as investors have turned more optimistic. Economic growth has been robust, with the most recent quarterly reports showing a 4.6% gain. Housing starts and home prices have been rising in most markets, especially the Bay Area. While the data on new jobs has been decidedly mixed, the stock market has moved steadily upwards, except for brief declines in January, July and October.

QE, the bond-buying program which the Fed has used to stimulate the economy, completely ended in October. Janet Yellen, Federal Reserve Chair, has said that the Fed will keep short term interest rates at current levels for a prolonged period of time. The yield on the 10-year note has declined from 3.0% at the end of 2013 to 2.35% by August, 2014. Since then, it has risen, as bond buyers anticipate the end of QE and look to riskier instruments in a search for yield. These higher rates and the robust economic reports have incentivized foreign investors to move funds to the US. As a consequence, the dollar has been rising.

This week, we will see the results of the mid-term elections. Right now, the odds look to be in favor of the Republicans winning majorities in both the House and the Senate. If this occurs, we expect little will get done in Washington over the next two years. Political cooperation, already an elusive approach, will likely hit new lows. Meanwhile, the “wealth gap” continues to widen. In the US, a small minority has benefited from the rise in asset prices. The rest of the population will need wage gains to catch up. With unemployment hovering at 6%, this is unlikely to happen soon.

Outside the US, economic growth is tepid at best and is slowing in many places. Europe is teetering on the brink of deflation, with Germany and France both sluggish. Growth in China, if we can believe the official state statistical reports, is also slowing. Military conflicts in the Ukraine, Syria, Iraq, and Israel are human tragedies, but are not likely to expand further and should therefore not materially affect world markets.

Economic disruptions due to new technologies have been accelerating over the last twenty years. The advent of email in the 1990’s changed communication. Ten years ago, search engines altered the way we find information. The advertising revenue model that Google pioneered has spread broadly into social media. As a result, the way we acquire many goods and services is now completely different. We think the future will bring even more changes. For example: electric cars? Hydrogen fuel cell cars? Magnetic levitation trains? Delivery by drones? Some or all of these will change the face of transportation. But these types of changes are part of the creative destruction process that makes capitalism in the US so dynamic, enabling us stay at the forefront of the world economy.

So whither go the markets? Bonds will be challenged by the absence of QE and the absolutely inevitable rise in interest rates. It is hard to make money investing in bonds when the difference between yields and inflation is near zero. We think stocks have further to go; however, they will not rise in a straight line. When the Yellen Fed first increases the Federal funds rate, we expect the stock market to fall sharply initially. After a 10 to 15% drop, the stock market will wake up to the fact that the reason for the rate increases is higher economic activity. This eventually brings higher earnings and stock prices. We think this Fed-driven reaction will precede the eventual euphoria-driven top, which may be years in the future. Accurately predicting when this will occur is impossible. In the meantime, we recommend all clients have enough ready cash to weather the volatility that is likely to ensue.

Individual investment positions detailed in this post should not be construed as a recommendation to purchase or sell the security. Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Employees and/or owners of Nelson Roberts Investment Advisors, LLC may have a position securities mentioned in this post. Please contact us for a complete list of portfolio holdings. For additional information please contact us at 650-322-4000.