Should stock investors sell now? It’s been a good year for stocks — for the year-to-date period ending September 30, 2016, the Standard & Poors 500 has returned 7.84% despite the year’s rocky start in January and early February. But has performance been too good?
Seven-and-a-half years into the bull market, valuations are high and there may be little upside in stocks between now and year-end. Volatility has started to increase modestly in recent weeks after a summer period that saw unusually low volatility in the equity markets. So, we may be due for a pullback.
Add to that, October has sometimes been a month characterized by high volatility, especially during an important Presidential election. These factors beg the question: should you sell now? Certainly taking some profits or rebalancing portfolios according to your regular plan is prudent. But in this commentary I lay out reasons why making more dramatic changes in your investment allocation may not be the best move.
Are Stocks Too Expensive?
Some investors think stocks are expensive. In fact, the LPL Financial Research department explained in a research note last month that the S&P 500 price-to-earnings ratio (PE) using the median calculation is more than 50% above its long-term average. Traditional market cap weighted valuations are also high — the current PE of 18 (trailing four quarters) is above the average of 15.2 going back to 1950, and even above the higher post-1980 average of 16.4.
But are high valuations a reason to sell? Not necessarily! Valuations have not been good predictors of stock market performance over the subsequent year, according to the LPL Financial research note. Other credible investment research has reached similar conclusions.
The correlation between the S&P 500’s PE and the index’s return over the following year, at -0.31, is relatively low (based on 45 years of data). Stocks can stay overvalued longer than we might think they should, so I instead recommend focusing more on macroeconomic fundamentals, and technical factors, not valuations, for indications of an impending market correction or bear market.
Valuations were a reason to sell during the tech bubble, but it was hard to tell when. The one-year return for the S&P 500 from March 31, 2000, at a PE of 28.2, was -21.7%. But valuations were high well before that, suggesting that even at extremes, predicting market direction using valuations is an inexact science at best. Starting in June 1997, with the S&P 500’s PE over 20, the S&P 500 produced gains of 30.2% and 22.8% over the two subsequent 12-month periods.
The relationship between stock market performance and valuation gets much stronger when looking at longer time periods. Once again, a recent report from LPL Financial Research showed that, when plotting PE against stock returns over the subsequent 10-year period, the correlation (negative) is quite strong.
LPL Research found that, as PEs rise, subsequent returns are lower; and vice versa. Eyeballing the two charts it is easy to see the difference, but we can put numbers on it. The correlation between PE and returns over the next 10 years is -0.87, a much closer relationship than PEs and one-year returns at -0.31 (-1 is perfect negative correlation and 0 equates to no correlation).
More Reasons To Hold Your Current Equity Allocation
Valuations may not be good reasons to sell, but are there, in fact, reasons to consider buying here? In spite of the solid returns so far this year, further equity market gains would not be shocking given the following factors:
Odds For Recession May Be Low
Many market experts, including LPL Financial, JP Morgan Asset Management, and others continue to see the odds of recession over the next 12–18 months as being in the 20% range based on leading indicators and few signs of excesses in the economy that might lead to major imbalances. If a recession is more than a year away, based on data back to 1950, the odds are over 80% that the S&P 500 delivers a positive annual return.
Favorable Monetary Policy and Low Interest Rates
If the economy weakens further, the Federal Reserve (Fed) may deliver additional stimulus. The Fed could state its intentions to maintain low interest rates for longer, or potentially initiate another round of quantitative easing, i.e., more bond purchases. Investors may understandably not like the idea of primarily relying on Federal Reserve Bank policies to prop up stocks, but the fact remains that markets have responded to them. Furthermore, low bond yields (also a result of Fed policy) continue to enhance the appeal of stocks.
A Rebound in Corporate Earnings
Future earnings estimates have tended to run high historically and are almost always subject to change. However, the economic data, along with stability in oil and the U.S. dollar, suggest an earnings rebound may be quite achievable. Current earnings growth expectations based on Thomson Reuters consensus data for the fourth quarter of 2016 and first and second quarters of 2017 are +8%, +15%, and +13%. Remember, markets tend to look about six months ahead.
Fourth Quarter Rally?
The S&P 500 has historically performed well during the fourth quarter with an average gain of over 4% (versus a 2.1% average for all quarters), with gains 79% of the time going back to 1950. Fourth quarters of election years are no better than an average quarter, but excluding 2008, the average fourth quarter gain during an election year is 3.6% and the S&P 500 is higher 87% of those quarters. We continue to believe that markets should welcome greater clarity on the potential election outcome when it arrives.
Valuations and seasonality do not appear to be good reasons to sell stocks right now. In fact, a number of factors I have discussed here suggest stocks do offer the potential for growth between now and year end. Although it is also possible that future gains may be limited, don’t be surprised to greater volatility and consider using temporary equity weakness to buy at lower prices.
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 referenced 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. Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal, and potential liquidity of the investment in a falling market.
Because of its narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies. All investing involves risk including loss of principal.
Correlation ranges between -1 and +1. Perfect positive correlation (a correlation co-efficient of +1) implies that as one security moves, either up or down, the other security will move in lockstep, in the same direction. Alternatively, perfect negative correlation means that if one security moves in either direction the securitythat is perfectly negatively correlated will move in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation;they are completely random.
The PE ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher PE ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower PE ratio
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 stocks representing all major industries.
This research material has been prepared by LPL Financial LLC.