Do you remember when your favorite record had that scratch that caused your favorite song to repeat the same phrase over and over again?
At this point of the year, I feel like a broken record.
On my blog on March the 3rd, I wrote the following,
“In fact, we believe that one should expect continued volatility in the equity markets in the near term. Our rationale for our outlook is based on familiar themes such as China, the divergence of monetary policy between central banks, and the age of our current economic expansion.”
Little did we know at the time that the UK’s choice to leave the EU would be the trigger for renewed volatility.
Our outlook for continued volatility in the markets remains.
There are a number of reasons.
Corporate Profit Growth
Corporate earnings growth has been negative for four consecutive quarters. As we start the quarterly earnings season, we anticipate another negative quarter in earnings growth. There is a clear past correlation in earnings growth declines and declines in the market. This causes us to be very cautious in our outlook. Estimated earnings growth for the second quarter estimate is approximately -5.0 percent.
Source: FactSet, Standard and Poors
Corporate Valuations
The S&P 500 PE ratio is approximately 24 and the Schiller PE ratio is approximately 26. To put these two numbers in perspective the long term mean for the S&P 500 is currently 15.60 and the Schiller PE mean is 16.68. Both of these metrics point to the expensiveness of the equity market. In addition, the price to sales ratio is the highest since the end of 2000.
Source: Standard and Poors
Market Length of this Bull Market
We are definitely long in the tooth on this bull market run. This is the second longest bull market for the US equity market. To put valuations in perspective, let’s look at valuations of the market during the longest bull market, which lasted from 1987-2000. In November of 1987 the Schiller PE ratio was 13.59. When the bull market ended in August of 2000, the Schiller PE ratio was 42.87.
Source: Standard and Poors
Why Are Valuations Important?
If you had purchased the S&P 500 on August 1 of 2000, the last month of the longest bull market, you would have had to wait until April 25, 2007 until you surpassed the price that you paid roughly seven years earlier. In other words, you went roughly seven years with just a dividend.
It is interesting to note that the market reached another peak in October 2007, the
Schiller was at 27 (remember we are currently at 26), we then endured the credit crisis and the market did not surpass the October 2007 peak until February of 2013.
Valuations are tremendously important in constructing and maintaining a portfolio since they are a key driver to portfolio returns.
Source: Standard and Poors
Fixed Income
We are currently in record low territory in terms of yield regarding US treasury ten year and thirty year bonds. This is due to a number of factors which include negative yields in other countries and the overall uncertainty in the global economy. Due to these factors, it is uncertain if we will have an interest rate increase from the Federal Reserve during this calendar year. Lower rates for longer seem to be the consensus in the industry.
Bonds will eventually face a headwind of rising rates but not at this point in time.
Foreign Investments
We continue to see value and the prospect for returns in foreign markets both in developed and emerging markets. However, we also expect continued volatility in these markets as well.
What Should You Do?
Market timing is almost an impossible exercise. However, decreasing exposure to an elevated market seems prudent. We have decreased exposure to US equities, especially for our retired clients who take distributions from their portfolio.
In addition, I believe it is important to review your risk profile. If you have not taken a risk profile test with our firm please contact us.
Keep a long term outlook. Having observed investor behavior for nearly thirty years, I have unfortunately witnessed many investors doing the wrong thing at the wrong time. Changing your portfolio construction out of fear in the middle of a downturn is normally a big mistake. Equities are long term assets and should be viewed as such.
In summary, our outlook has not changed for the near term. Your portfolio construction should match your long term goals but also take into account the expensiveness of US equities.
Monte
