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View from the Peak

By Richard Tomes June 26, 2017 Market Watch

Is It A Peak?

 

Since the market low on March 9, 2009, the S&P 500 has risen 249% through March 31, 2017 (see JP Morgan Guide to the Market Quarterly, Q2 2017 – page 4.) Year to date 2017 through June 22, 2017, the S&P 500 has risen 9.81%.

 

Due to the long expansion, it certainly feels like it might be time for a correction or even a bear market. Yet, many analysts are repeating the old adage, “Bull markets do not die of old age.” Historically, markets can advance for a long time and the length of the expansion over time is not necessarily an indicator.

 

Stocks are often valued on the price of the stock relative to its earnings. This is called a Price-to-Earnings Ratio, or, “PE.” If a company is earning $1 per share per year and its stock is trading at 16, then one would say, “It is trading at a 16 PE.” The 25-year historical average PE for the coming year for the S&P 500 is 15.9 (Ibid., page 5). The current estimate for the coming year for the S&P 500 is estimated to be 18.75 (http://www.wsj.com/mdc/public/page/2_3021-peyield.html ). The same page references that a year ago the PE was 23.85. Given the historical average is 15.9, one could presume the market is overvalued at 18.75 by about 17.9%.

 

Yet (back to JPMORGAN Guide to the Market Quarterly – 2Q 2017, page 4), PE may not always be the correct indicator for a market peak. On Dec. 31, 1996, the PE was at 16.0 and expanded upward to the peak on March 24, 2000 at 27.2 PE. The next peak was Oct. 9, 2007 at 15.7.

 

A lesser known and referenced indicator of the S&P 500’s valuation is the Yield-Adjusted PE Ratio. This compares the PE to the 10-year Treasury yield. The long-term historical average of this gauge is 23 (going all the way back to 1960). On Tuesday, June 20, 2017, the Yield-Adjusted PE Ratio for the S&P 500 was 23.9. (http://theonedave.tumblr.com/ , June 21, 2017 Chart of the Day). Based on that indicator, it would seem that the S&P 500 may be only slightly overvalued.

 

Economy and Legislation

The current economic recovery and expansion has been much slower than historically since WW II. (Cf. JPMORGAN Guide to the Market Quarterly – 2Q 2017, page 18, right chart.) Given the slowness of the recovery and expansion, there may not have been much excess build in the economy. Usually, a turn in the stock market downward occurs after a relatively long expansion in the economy, leading to more earnings for corporations and an exuberance that gets out of hand leading to excess (as with the housing crisis of 2008). Based on the growth rate of the economy, it seems unlikely that a lot of excess has built up yet and that could indicate that the economic expansion and the increase in corporate earnings might continue for some time.

 

Current pending legislation could significantly affect prospects for the economy and US companies. The proposed reduction in corporate tax rates could substantially lower PE’s across the board. The E in PE (“earnings”) is based on the earnings of a company after taxes. If the tax rate for corporations is lowered substantially, all of a sudden the PE drops because the companies will have more E left to them instead of going to the Government in taxes. Thus, it could turn out, if the proposed cuts are eventually passed, that the PE would drop and stocks could be expected to see their prices rise to get back to an average PE. There is other pending legislation that could also have positive effects on the economy.

 

Risk

 

There is always a risk of a catalyst that might change the direction of stocks downward. It could be a slow, mundane catalyst like the failure of anticipated legislative actions that may be somewhat priced into the stock market. Or, there could be a shock, something unexpected, such as a political event, war or something about which no one is even thinking. In such a case, then it would turn out that the stock market might be at or near a peak now and about to change directions for a period of time.

 

What to Do?

 

It can be very scary to begin investing when markets might be near a peak. This is most true with “new money” to be committed to investments that is currently in cash. In such situations, a wise approach might be to ease the money into investments over a period of time. Often, 10% a week or every other week for a period of time could be a wise approach. That way, if the markets continue going up, the investor will have been getting into the investments with at least some money at lower prices. It also gives the investor the ability to watch conditions evolve over time to decide if more investments are warranted, or if it might be wise to pause further investments until things are more clear.

 

For investors already invested, it would be good to review the strategy one has and why that strategy was chosen. Also important is the time horizon for the strategy. For many investors, a strategy is in place meant to reach certain goals over a long period of time and consists of stocks, bonds, cash and perhaps other kinds of investments. If the strategy is still appropriate, it is often a wise policy to stick to the long-term strategy. If one is concerned a peak or catalyst may be near, some tactical tweaks may be in order, “Just in case.” The tweaks could be raising some cash and holding the cash, or buying bonds with some of the raised cash. A total disruption of a strategy often results in disappointment as the fear may not be realized and then one would need to buy back sold investments at higher prices than sold. History teaches students of the markets that timing changes in markets and individual investments is very hard to do. This has led to the adage, “It is not timing the market, but time in the market.”

 

Conclusion

 

Are we at a peak? Will markets continue to expand? Will there be a correction? Will there be a bear market soon? I have no idea and, while sometimes guessers get lucky, no matter how many credentials or accolades a prognosticator might have, no matter how convincing they might sound, they, too, are just guessing.

 

The wise thing to do is devise a strategy for investing based on analysis of an individual’s particular situation. Invest into that strategy, perhaps over a period of time, then stick to it with only minor tactical changes. Realize, too, that there are many who make their living making investing seem exciting, when in reality investing is something that takes time. Understanding that investments are expected to go up and down over various periods and cycles and how those expected movements fit into the strategy chosen should help to ease nerves and help to avoid panic selling and the remorse that usually follows.

 

We are here to help. We are always glad to help to review a strategy and its fit. Please, contact us directly with any concerns.

 

Cheers,

Richard Tomes, CFP®

President

Total Wealth Planning and Management, Inc.