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.
IMPORTANT DISCLOSURES
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.
INDEX DESCRIPTIONS
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.
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