The fear that new stock market heights might lead to a sharp downturn can prompt costly decisions.
With indices posting all-time highs, it is interesting to see market participants’ reactions. Here are just a couple of comments from analysts we have seen published in major financial news publications in recent years:
the measures (trailing price-to-earnings ratio, forward P/E ratio and cyclically adjusted P/E ratio) is currently higher than its long-term average, prompting many market analysts to predict an impending market decline.”
“You guys have enjoyed the party—there are a lot of people dancing. But I think that could be pretty dangerous. I’d say the last couple of 10 percent declines were a sign that the band is about ready to go home.”
are only two of many similar comments made when stocks have reached record highs. The sentiment expressed in these comments have prompted a kind of acrophobia that has been very costly.
For instance, the S&P 500 is up more than 25% since the date in late summer 2017 when the first excerpt above appeared. Meanwhile, roughly eight months after the second excerpt to now, the S&P 500 is up 16.46%.
The S&P 500 this year has set 22 new all-time highs, but the index also set new highs 45 (2013), 53 (2014), 10 (2015), 18 (2016), 62 (2017), and 18 times (2018), respectively, in the seven years from 2013 through 2019. Liquidating an equity portfolio at any point during these seven years would have missed the significant benefits of a broadly rising market.
Finding Some Certainty in the Uncertain
In isolation, a new high for any market measure is irrelevant. It is just a number. What that number represents in fundamental and technical terms, however, is important. Relieving the jitters investors might experience as stocks ascend requires taking
a broad view of the situation. Investors should consider the following:
- Expected earnings growth
The equity market is always looking ahead, often by as much three or more quarters. A positive trajectory to expected earnings growth typically is not present if the market is close to a major downturn. Current and expected earnings are major parts of valuation. Although they can vary widely, comparisons of earnings (current and forward price-earnings ratios) viewed in a well-established historic range often provide a good guide to the market’s potential. Today, 2020 S&P 500 earnings are expected to be more than 8% greater than are likely to be reached this year, which on its own suggests the market might at least match next year’s anticipated earnings growth.
Market valuation also has to be considered in the context of interest rates. High interest rates compress price-earnings ratios while low rates tend to boost them, which is why the equity market is highly sensitive to both current and expected Federal Reserve credit policy. The market’s 17.7 times forward price-earnings is not on the low side of typical market valuation, but it is not at a level that historically has led to major market pullbacks.
- Federal Reserve credit policy
The Federal Reserve sets the level of interest rates, but in the context of its policy statement, it frequently offers the market hints of the possible direction of credit costs. The Federal Reserve’s currently highly accommodative credit policy and its expressed desire to keep credit costs in a range that fosters growth justifies the market’s current and possibly higher valuation.
- Gross domestic product (GDP) growth prospects
GDP growth potential has wide-reaching implications, as it can influence the previous three points.
No matter how many highs are posted, the market seldom moves in a linear manner. Interim pullbacks occur with great frequency. As long as the four major points outlined above remain in acceptable ranges, investors need to resist the temptation to react
negatively to interim pullbacks that in a bull market are inconsequential.
A time will come when one or more of the key points will warn of a significant market drop. This in our view is not that time, but constant vigilance of the four key points is necessary to recognize when that time arrives and a defensive posture is called for. Until then, succumbing solely to market-related acrophobia can be detrimental to a portfolio’s health.
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