- The long run of strong investment performance has left valuations higher, and rising rates and an economy approaching the late cycle present headwinds.
- Stocks won't necessarily suffer a major decline, but investors should lower their expectations, as I believe the strong returns and low volatility of recent years appear unlikely to repeat.
- It may be a good time to consider rebalancing.
From March 2009 to January 2018 the S&P 500® gained 364%, generating a compound annual growth rate twice the historical average, amid much lower volatility. A "60/40" portfolio (60% stocks and 40% bonds) has done spectacularly well, as both equities and bond prices have gone up together, which they are not usually "supposed" to do. It has been the best of all worlds. But there is no such thing as a free lunch, and the results are elevated valuations everywhere. In recent days, trade risks and privacy concerns in the tech sector have driven renewed volatility. In the bigger picture, the economy seems to be inching ever closer toward late cycle, and the Federal Reserve has signaled an even tighter policy path than the markets were expecting. That's a headwind for equity valuations and, given the Fed’s policy, for bonds as well.
With these headwinds for stocks and bonds, last week a client asked me: "What exactly are we supposed to do now?" There are some actions that some clients with a shorter-term focus may want to consider, including perhaps adding cash and inflation protection to a portfolio. But the main takeaway I can offer is this: It may be time to lower your expectations.
So if we aren't going to see a repeat of the last few years, what can we expect? I have good news and bad news ... and then some more good news.
Earnings growth looks strong
Here's some good news: Over the long run, stock prices generally follow earnings, and earnings are going up. Growth is a tailwind that will forgive many sins.
This is important because earnings grew 11% last year, are expected to grow 21% this year, and another 11% next year. That kind of earnings momentum will go a long way toward limiting losses, even as valuations reset.
Valuations are under pressure
Now for the bad news: When valuations are this high (21× trailing 12-month earnings for the S&P 500 and 19× forward earnings, at the recent peak), and the risk-free rate1 and equity risk premium2 are this low (2.8% and 1.8%, respectively, at the recent peak), financial conditions matter. A lot.
One valuation method can help illustrate this: the discounted cash flow model, which attempts to estimate the value of future earnings in today's dollars. At current levels of rates and risk premiums, a mere 1% increase in the discount rate (from 4.7% to 5.7%) would shave nearly 4 P/E points off the stock market’s fair value on a trailing earnings basis.
It's no different in the bond market. A move from a yield of 2% to 3% is going to impact returns much more than a move from, say, 10% to 11%.
This means that at current valuations, the stock market has to really thread the needle—to stay up while valuations come down. It has happened before, but only rarely. It will be a tug-of-war between earnings growth in the numerator and liquidity conditions in the denominator. Together they drive valuation.
Why should the market's P/E multiple be coming down? For one, we are approaching the late cycle, with full employment and inflation and presumably tighter monetary policy (the Fed turned slightly more hawkish last week).
And now, we also have some valuation headwinds in the form of protectionist trade policy. Tariffs and other protectionist measures are a form of de-globalization. If the era of globalization brought stronger growth and lower inflation, then the reversal of globalization could bring the opposite (less growth and more inflation).
Threading the needle
The last piece of good news: The market actually has been (sort of) threading the needle. Since its January high, the S&P 500 is now down exactly 10%, but the forward P/E ratio is down 16% already, from a high of 19.4× on January 26 to Friday's close of 16.3×. I am quite encouraged by this, and it's a testament to how strong earnings growth is expected to be.
And remember, historically a 10% correction is really not a big deal for stocks. For the Dow Jones Industrial Average, since 1926, the odds of a 10% correction happening are 1 in 3—they are par for the course when it comes to the stock market's value proposition (which is that the price for higher returns is higher volatility).
A reminder about rebalancing
Did you know that since March of 2009, a hypothetical portfolio of 60% S&P 500 Index stocks, and 40% bonds would have turned into a portfolio of 83% stocks and 17% bonds if it had not been rebalanced by now? That would make a 10% or 20% decline in the stock market hurt a lot more. So, don't forget to make sure that your investment mix is appropriate for your risk tolerance, goals, timeline, and financial situation, and to rebalance!
Next steps to consider
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