Are you concerned about the stock market’s meteoric rise this year? Is it all huff and puff? And are your investments about to get blown down? Have the speculators driven prices up to far and too fast?
I got a few calls last week from clients asking these and other questions. They wonder if it isn’t time to take some of those sweet profits off the table. You might be asking these same questions.
Let me start off by saying that nobody knows what the future holds. I don’t know what is going to happen in the market over the next day, week, month, year or decade.
But when people get nervous they sometimes do funny things with their money they later regret. Let’s take a rational look at the market to get a sense of where we are now and what we might be looking at down the road.
Historically the market has done well during the holiday season. On average the market gained 2.6% between the day after Thanksgiving and the day second day of the new year according to the Stock Trader’s Almanac.
That’s interesting but not nearly enough information to make a “buy or sell” decision around. Let’s look at valuations instead. They are often a far better indication of risk. High valuations can lead to nasty stock market declines.
One of the most important valuations is the Price to Earnings Ratio or PE of the S&P 500. To calculate this ratio, market watchers first tally up what it would cost to buy one share of each of the companies in the S&P 500. Then, they look at the earnings per share of each of those firms and add that up for all 500. They put this together by taking the cumulative price and dividing it by the cumulative earnings. For example, if the cumulative cost was $20,000 and the cumulative earnings were $2000, the PE would be 10. Make sense? I knew it would.
Historically, the average PE for the S&P 500 has been about 15. But currently the PE is 20 if you use the S&P’s trailing income. So that looks pricey. But if you look at future earnings, the PE comes back down to 15 which is a little bit more in line. I think it would be reasonable for any investor to conclude that based on the PE, the market is either fairly valued or overvalued. That being the case, they might conclude that there is little upside potential and they might sell as a result.
There is logic to this approach but I don’t think that the PE for the S&P 500 tells the entire story. I feel this way for 3 reasons:
1. Interest Rates
Remember that people don’t’ make investment decisions in a vacuum. When it comes to financial assets, people choose between stocks, bonds and cash. Right now, bonds and cash are paying just about nothing. That makes stocks look relatively attractive. That might support higher PE ratios.
2. Federal Reserve
The economy is expanding but ever so slightly. The Fed is doing everything it can to keep that train moving. One way they do that is by pumping lots of money into the economy. That is exactly what happens when the government buys bonds. In fact the Fed is buys $85 billion worth of bonds every month.
When they pump that money into the system, it has to go somewhere. Some is spent of course. That creates demand and (hopefully) more jobs. But some of that money ends up being invested. And since bonds aren’t paying very much, an important chunk of that money goes into buying stocks. Since there is more money chasing stocks, the stock market rises.
3. Private Sector
This rush into equities isn’t only fueled by the government. Individual investors continue to reposition their money out of bonds and into equities too. That’s pushing prices up as well.
On top of that, private corporations are very healthy these days. According to Investor’s Business Daily, corporations are sitting on piles of money – $1.14 trillion to be specific. That means private companies have a lot of money to invest and grow their business with. If they are able to grow profits, the PE drops and stocks become relatively more attractive.
The Important Take Away
The most important conclusion I hope you take away from this post is that there are compelling reasons to be both bullish and bearish. And you know what? It’s always like that. There are always two sides of the story.
Yes it’s important to understand that different forces that influence the market. But it’s more important to understand that nobody can predict the future. When it comes to investing, there is never a certain outcome. And this is especially true over the short-term.
I’m not saying that you should always buy and hold your investments. While that might be a good strategy for some investors, it may not work for others. Personally, I like a more dynamic approach.
Whatever your investment model is, I suggest you continue to monitor your results over the long-run rather than trying to predict the future of the financial markets.
Are you worried about stock market valuations now? What are you doing about it?
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