One of my investors recently posed a question to me that has been on everyone’s mind for a few months. Are the markets primed for a correction? To wit we begin an analysis of this question. But before I begin my analysis, the short answer: I don’t know. The comforting corollary to this answer: nor does anyone else. We will revisit later on how to deal with this uncertainty.
One simple gauge of market valuation is price, as it is of any other asset. Your neighbor’s house sold for $220,000 last month. The same house sold for $200,000 last year. Therefore homes in your neighborhood are approximately 10% pricier now compared to last year (we’ll ignore inflation in our analysis) and are therefore that much less attractive on a price basis. However, price by itself doesn’t convey the total picture. Since buying the house last year, your neighbor may have added upgrades worth more than $30,000. Rental values in your neighborhood may have gone up 20% compared to last year, especially for homes with such upgrades. Together, this may suggest that, despite the 10% increase in price, the house that sold at $220,000 now may actually be more valuable than the one that sold for $200,000 last year.
We can analyze the stock market in similar terms. The S&P500 closed at 2373.47 today. A year ago to date, the market closed at 2049.80, about 15.8% lower than current levels (again we will ignore the effects of inflation for ease of analysis). Therefore, like your neighbor’s home, the stock market is pricier today than it was a year ago and, on a purely price basis, is less attractive today compared to last year.
However, we don’t view price in isolation but relative to the earnings potential of the stock (just like the rental potential of your neighbor’s home compared to its price). For example if the Earnings Per Share (EPS) of the S&P 500 is 100, then the PE (Price/Earnings ratio) is 2373.47/100 = 23.73. The higher this number the more you are paying per dollar of earnings and therefore the less attractive stocks are.
Luckily for us, we don’t need to calculate these numbers but can instead rely on an oft-quoted gauge of market valuation, the Shiller Cyclically-Adjusted Price/Earnings Ratio (CAPE) for guidance. The CAPE is currently at 29.24 compared to 25.92 at the end of March 2016. In other words, if we buy stocks now compared to a year ago, we are paying $29.24 per dollar of earnings, compared to $25.92 last year.
But the analysis of assets is a little more complex than just an analysis of price levels and past earnings. What about future earnings potential? Let’s go back to the example of your neighbor’s home. What if the suburban transit system that skipped your town because it was too small, suddenly decided to add your town to its roster of stops? What if the rating of your local public high school just made a well publicized jump to the list of top 10 schools in the country? Your town just got a lot more attractive to live in. There is a sudden increase in rental inquiries and your new neighbor, who listed his house for rent, has his phone ringing off the hook by prospective tenants. Guess what, he just marked up the rental price of the home and the value of his home went up correspondingly. On the day the US presidential election results were announced the S&P500 stood at 2163.26. Since then the market has gone by approximately 10%. What could account for this rise? As we know, the market trades at a multiple of earnings and if those earnings go up, certainly prices have the potential to rise. More importantly if the market anticipates rises in future earnings potential, that can act as a strong catalyst for an upward movement in prices. According to Factset (Earnings Insight, 3/17/17), 71% of companies have so far given negative earnings guidance for Q1 2017 compared to only 29% with a positive guidance.
So, at least in the short run, a jump in earnings expectations is not on the cards. However, what if, like the example of our town with its announcements of a new transit stop and the high achieving public school, the economy as a whole has had some positive catalysts? Wouldn’t that help the market go higher? That certainly seems to be the case. Since Donald Trump was elected President, a trifecta of policy changes have been announced that have the potential to boost stock prices: 1) increased infrastructure spending 2) tax reform and 3) business deregulation. In the absence of other factors, we have to assume that the market has risen on account of the anticipated positive benefits of these proposed changes. However, it is important to note that these changes are already reflected in stock prices. In other words, it may be a long time before these policy changes actually come into fruition, if at all, but the market has already anticipated the positive impact of these changes. Should these changes fail to materialize in the manner that the market currently anticipates, this will cause the market to give back some of its gains.
Let us revert to a historical analysis of the CAPE. Looking at a chart of month-end CAPE values, you will have to go back to March 2002 to find a level similar to today’s level of 29.24. Going back to January 1, 1881, the market’s long-term mean and median are 16.73 and 16.12 respectively, while it’s high and low points were 44.19 (December 1st, 1999) and 4.78 (December 1st, 1920). In near term memory, it hit a low of 13.32 on March 1, 2009. This is certainly not a bargain market, though as we have seen before in 1999 and 1920, markets can overshoot depending on the prevailing market sentiment (panic or greed). Unfortunately, many individual (and even some institutional) investors tend to buy at the peak (for fear of losing out on further upside) and panic and sell at precisely the wrong time i.e. when the market has bottomed out. Market peaks and troughs are only obvious in hindsight.
We will be remiss not to discuss Fed actions and the market. After all, we have witnessed the most extraordinarily accommodative central bank era in history. As the global economy teetered on the verge of a global depression in 2008-09, central banks around the world pumped in money and ushered in a period of zero and even negative interest rates to stimulate the global economy. As a result the US has witnessed steady (if not spectacular) economic growth and rising asset prices. When interest rates are near zero, both savers and investors are forced to resort to riskier assets and the stock market has certainly been a beneficiary of those actions. However, with an economy running at historically low unemployment rates and the appearance of upward pressure on wages, the Fed has recently reversed course and appears to be on course to raise interest rates at least thrice in 2017 with more to come in 2018. How does a rising interest rate scenario affect stock prices? Higher interest rates (read higher borrowing costs) should act as a headwind to stock prices. But the chart below (courtesy: Commonfund) may surprise you.
Going back to 1958, the market has actually gone up in twelve out of fourteen rising rate regimes. On average, the S&P gained an annualized 12.4% during these times. What could account for this? If rates rise primarily to combat high inflation, as was the case between February 1972 to July 1974, the market may not view these rate rises as a positive whereas if rates rise to cool down a very strong economy, it may reaffirm other bullish signals for market participants.
How do we make sense of the various signals on the market? The following table can help.
On the positive side we have an economy that is growing moderately in a benign inflationary environment and a pro-business government. However high valuation levels give us pause. Further the era of “printing money” seems to be over. Corporations may not longer be able to borrow cheaply to buy back their own stock, an action that has been positive for stocks over the past several years. Policy actions, while pro-market, may already be “priced in.” Geopolitical risks and their potential effects remain unknown.
Given this environment and the lack of a crystal ball, how are investors to react? It is time to revisit some fundamentals.
1) It is extremely difficult to time the market. Market peaks and troughs are obvious only in hindsight.
2) The majority of variation in returns is due to asset class selection rather than stock selection.
3) On average, active managers underperform the market.
4) Cash has optionality. In other words, market falls may provide the opportunity to deploy cash in a wise manner.
5) In the long run, only an equity bias can help you build your wealth.
Stick to your long-term plan. Revisit your financial situation and understand your own potential to take risk. Balancing your liquidity needs and ability to tolerate volatility with the need to maintain an equity bias is important. While the current market may prompt a more defensive stance, your own time horizon may be long enough to overcome pullbacks in any given market cycle. Low cost mutual funds and ETF’s are a good option to gain exposure to the market. Factor-based investing approaches can also be implemented through the use of ETF’s. Be agile, be resilient, and keep some cash handy.
Prabhu Palani is a proven investment strategist and portfolio manager with over 20 years of investment management experience with global leaders including Barclays Global Investors, Franklin Templeton Investments, and Mellon Capital. He has been a trusted partner in managing clients assets for several leading public and corporate pension plans, and endowments and foundations including CalPERS, CalSTRS, New Mexico PERA, Norges Bank, MassPRIM, Ontario Teachers, Arkansas PERS, The McKnight Foundation, and Mitsui. He possesses a deep understanding of both fixed income and equity markets with intimate knowledge of quantitative and structured approaches and risk management tools. He has had success in growing AUM from $1.5bn to over $20bn as Managing Director, Portfolio Manager, and Head Equity Strategist at Mellon Capital. While at Franklin Templeton he successfully added several marquee plan sponsors to the firm’s roster of institutional clients. Prabhu has managed over $15bn in client assets as a portfolio manager and has had supervisory responsibilities for an additional $15bn.
He has served as a speaker at conferences and has written several white papers and market commentaries. He has been published in the Financial Times and India Currents. He holds graduate degrees from Stanford University and the University of Delaware and has obtained both the CFA and CA designations.