Stock Market Valuations Suggest Bull Still Has Some Teeth

After hitting another all-time high on July 24, the S&P 500 Index fell for six

consecutive trading days, leading to a 2.7% drop for stocks for the week

ending August 1, 2014. Losing almost 3% in a week seems a minor concern

given historical market ups and downs, especially in the face of a strong bull

market that has seen a 220% gain since the market’s low point in 2009.

Nonetheless, investors may begin to wonder if stock market valuations are

signaling a larger impending market decline and possibly the end of this bull

market cycle.

Part of the fear over last week’s sell-off is that investors have not been

accustomed to drops in stock prices over the past two years. After all, it

has been a long while since we have seen a significant pullback. In fact,

this week marks the third anniversary of the last 10% or greater correction

in the S&P 500, which happened in the late summer of 2011 (July 22,

2011 – August 8, 2011). The catalyst at the time was the debt ceiling debacle

in Congress and the resulting downgrade of the United States’ credit rating

by Standard & Poor’s alongside the increased risk of a break-up of the

Eurozone. The stock market fell 17% during this two-and-a-half week period

(and dropped 19% peak to trough from the April 2011 high through the

October 2011 low).

Three years seems like a very long time without a 10% correction and,

frankly, it is. But it is not without precedent. Economic expansions

periodically offer long stretches of remarkably low volatility and a

preponderance of up days for stocks. Since the end of the last significant

sell-off for stocks (October 3, 2011), the market has been in a consistent

upward trend. The result is that it has been 1033 days since the end of a

period culminating in a double-digit drop for the S&P 500.

Three years seems like a very long time without a 10% correction and,

frankly, it is. But it is not without precedent. Economic expansions

periodically offer long stretches of remarkably low volatility and a

preponderance of up days for stocks. Since the end of the last significant

sell-off for stocks (October 3, 2011), the market has been in a consistent

upward trend. The result is that it has been 1033 days since the end of a

period culminating in a double-digit drop for the S&P 500.

Since 1980, three periods have gone longer without a double-digit decline

Keep in mind we came very close to that 10% mark in 2012, with

a loss of just under 10% in April through June of that year, and during that

time a number of market segments did lose more than 10%.

In a typical year, the S&P 500 endures an average of four 5% pullbacks.

Against this backdrop, we see this latest bout of volatility (roughly a 3%

drop in the S&P 500 since July 24) as normal, overdue, and frankly, healthy.

While we do not necessarily believe this latest bout of volatility is the start

of a 10% market correction — though it is possible — it is worth noting that

we have had only one 5% pullback so far this year (January 22 – February 5,

2014). As we move later in the business cycle, an increase in volatility is to

be expected. But at this point, based on our economic and market outlook,

we would view this slight sell-off and any more pronounced weakness as a

potential buying opportunity.

Valuations Not Overly Stretched

The current pullback has led to slightly more attractive valuations. With the

bull market having produced a total cumulative return of over 220% since

it began on March 9, 2009, it is no surprise that many investors and stock

market pundits have begun expressing concerns about stock valuations.

We highlighted the importance of valuations, looking specifically at priceto-

earnings ratios (PE), in our Mid-Year Outlook 2014: Investor’s Almanac

Field Notes publication, where it is included as one of our five “forecasters.”

These five key indicators, which include valuations, have consistently and

reliably signaled the increasing fragility of the economy. Furthermore, they

have marked the transition to the late stage of the business cycle and have

foreshadowed the likelihood of a recession.

PEs are the most commonly cited metric when measuring stock market

valuations. PEs measure the price of a stock market index, or single stock,

relative to corporate profits, or earnings. Observing the PE ratio of a broad

index such as the S&P 500 can measure how expensive the broad market

may be. The lower the PE, the more attractive stocks are and vice versa.

However, there are three very different versions:

  • Trailing PE, the price divided by the past four quarters’ earnings per

share for companies in the S&P 500 — currently at about 16.9 (and our

preferred measure);

  • Forward PE, the price divided by the Wall Street analyst consensus

estimate for the next four quarters’ earnings per share — currently at 15.2;

  • Cyclically adjusted PE, or CAPE, the price divided by the average of 10

years of earnings, adjusted for inflation — currently about 26. As a note, we

rarely use the CAPE, which has been saying for five years now that stocks

are overvalued even as one of the most powerful bull markets ever seen

has taken place. It is our opinion that the CAPE fails as an investing tool for

several reasons, among them the arbitrary 10-year adjustment period, which

is longer than most actual cycles and therefore distorts the “cycle” average

for earnings. In addition, huge changes to the index constituents over the

past 10 years almost render the CAPE useless. So many big companies

were not even in the S&P 500 Index 10 years ago, like Google (added in

2006) and Amazon (2005), while AIG was one of the largest constituents

and Lehman Brothers was in there as well (and obviously is not now).

Valuation Is a Useful but Blunt Tool

While of paramount importance to investment returns over the long term,

there is no relationship over the short term between the level of the PE and

stock market performance over the following year. As a result, valuation is a

poor market-timing indicator. In other words, valuation is like brushing your

teeth — you know it is important over the long term, but its significance

and impact is at some time in the uncertain future. Like regular brushing,

monitoring valuation can help you take care of the health of your portfolio in

the long term, but it won’t tell you what’s going to happen in the next year.

Thus, while valuation should always be considered, it is a blunt tool — like a

toothbrush — that should be taken into broader context.

The current trailing PE of 16.9 is above the long-term average (since 1927)

of about 15, but it is far from the peak of 2000, and it remains in line with

the average since 1980. Nevertheless, it is approaching an important range.

Since WWII, every bull market has ended with a PE between 17 and 18,

with the exception of the bull market that ended in 2000, which peaked

much higher. This is not to suggest the PE could not go higher than it is

today. In past cycles, PEs did reach higher levels before ending up between

17 and 18 as the stock market peaked. We also note that earnings are on

pace for the high single-digit gains that we forecast for this year, and as a

result, very little, if any, PE multiple expansion is required for the S&P 500

to reach our targeted return range for 2014 of 10 – 15%.

Weeks like last week drive investors to search for a reason to justify the

modest sell-off. Although there are many potential culprits, valuation is likely

not one of them. Stock valuations remain slightly elevated but not at levels

to spark selling pressure or concern. That said, valuations at current levels

do suggest the bar for growth has been raised and stocks are likely more

vulnerable to any economic deterioration if growth does not materialize

in the second half. However, amid the equity market losses of last week,

economic data continued to validate a strengthening economic backdrop,

including a healthy July jobs report, above-consensus second quarter gross

domestic product (GDP) results, and a better-than-expected ISM report for

July (please see this week’s Weekly Economic Commentary for details).

These strong results are important since solid growth, not valuations,

remains the most important catalyst for fueling stock market gains for the

remainder of the year. So keep brushing those teeth and looking out for

market “cavities,” but, for now, we would not be too afraid of the dentist.



The opinions voiced in this material are for general information only and are not intended to provide specific

advice or recommendations for any individual. To determine which investment(s) may be appropriate for you,

consult your financial advisor prior to investing. All performance reference is historical and is no guarantee

of future results.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no

guarantee that strategies promoted will be successful.


The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure

performance of the broad domestic economy through changes in the aggregate market value of 500 stock

representing all major industries.


This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

Not FDIC or NCUA/NCUSIF Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit




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