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Resisting the Siren Song of Stock Market Timing

By on January 7, 2014
Categories: D&Y UPDATES

We hope your summer is off to a great start and that you enjoyed a long, relaxing Fourth of July weekend with family and friends.

Stocks continued grinding higher in the second quarter, with U.S. indices hitting new highs at the end of June. Stock market volatility remains very low. One big surprise of 2014 has been the decline in interest rates (bond prices rising), despite the Federal Reserve cutting its purchases of U.S. Treasury bonds. The benchmark 10-year Treasury bond yield began the year at 3.0%; many forecasters had predicted that it would be in the 3.5% to 4.0% range by now. Instead, it finished the second quarter at 2.5%. One reason for the decline in rates has been the relative scarcity of new-issue Treasury bonds. With the federal deficit having declined from 10% to just 3% of gross domestic product, the government has had less need to issue new debt securities.

Fresh geopolitical troubles, however, pose some threat to continued market stability. In Eastern Europe, Ukraine continues its struggle against Russian activists in the eastern part of the country. Meanwhile, the dramatic rise of the militant group ISIS in recent weeks threatens to plunge Iraq into civil war. President Obama has deployed military advisors to the country, but is understandably reluctant to once again commit the U.S. to a larger effort.

Asset class returns for the second quarter and year-to-date were as follows:

 

Index Asset Class Second Quarter 2014 Year-to-Date 2014
Barclays Capital U.S. Int. Government / Credit Index Fixed Income 1.2% 2.3%
S&P 500 Large U.S. Stock 5.2% 7.1%
Russell 2000 Small U.S. Stock 2.0% 3.2%
MSCI All Country World ex-USA Foreign Stock 5.0% 5.6%
S&P Global REIT Real Estate Securities 7.9% 15.5%

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

– Peter Lynch

Many market observers and strategists have recently expressed incredulity regarding the ongoing stock market rally, and have subsequently prognosticated that some sort of market correction is looming around the next bend. Should you listen to them? Should you take action? As we’ve said before, trying to time entry into, and exit from, the stock market is generally quite hazardous to one’s financial health. Stock market prices move in mysterious ways. Over long periods of time, market returns are without question tied to economic fundamentals such as growth and corporate profitability, but in the short-term many other factors can introduce “noise” and distort the picture. The timing and magnitude of these other factors, such as geopolitical events and mass psychology, are inherently unpredictable and therefore nearly impossible to act on.

To illustrate the difficulty of deciding whether to embrace or abandon equities at a particular point in time, we lay out below both a bullish and bearish case for today’s U.S. stock market.

Reasons for optimism – Why today’s stock market could continue to march upward:

  • Interest rates remain very low across the board. Prospective returns on stocks remain attractive compared to those on bonds.
  • The S&P 500 Index appears fairly valued on a historical basis, with a forward price-to-earnings ratio of about 16. This suggests that even without a further increase in the P/E multiple, investors can expect annual returns on stocks equal to the dividend yield (2%) plus expected earnings growth (4% to 6%), for an expected total return of 6% to 8%. Furthermore, trending markets rarely “stop” at fair historical valuation; they tend to overshoot in both directions, suggesting this bull market may yet have room to run.
  • Low inflationary environments, such as we have today, have historically been supportive of higher equity valuations (higher price-to-earnings multiples).
  • Corporate balance sheets are in terrific shape, with many companies holding enormous hoards of cash. Many firms have taken advantage of the low interest rate environment to issue long-term debt, thereby lowering their cost of capital.
  • The rise of new technologies has sparked an energy revolution in the U.S., one which could well lead our country to energy independence within a decade.
  • We are about to enter the third year of the presidential cycle, which has typically been the best year for stocks. Furthermore, it appears quite likely that gridlock (Democratic presidency combined with Republican-controlled Congress) will persist following this fall’s midterm elections—and perhaps after the 2016 Presidential election—a state of affairs which also has been historically constructive for stocks.

“…trying to time entry into, and exit from, the stock market is generally quite hazardous to one’s financial health…”

Reasons for caution – Why a minor correction, or worse, could be near at hand:

  • By some measures, such as the cyclically-adjusted price-to-earnings ratio, the market is significantly (~30%) overvalued, suggesting lower returns ahead.
  • The market is simply “overdue” for a correction. The last major decline in the S&P 500 Index occurred between July and October of 2011—three years ago—when the index dropped 19%. Since the October 2011 low, the market is up over 80%.
  • Corporate profit margins, which have widened significantly since the financial crisis, are now at cyclical peaks. When margins inevitably begin reverting to long-term averages, corporate earnings growth will slow or even reverse course.
  • Geopolitical developments in the Middle East (Iraq, Iran, Syria) may lead to a spike in oil prices, hampering corporate profitability, and exacting a stealth “tax” on consumers through higher gasoline prices.
  • Inflation is admittedly still low, but it is rising, and the dovish Federal Reserve led by Janet Yellen may be unable to raise short-term rates to squelch this rise before it becomes problematic.
  • While the federal government has effectively addressed its near-term deficit, nothing has been done about the longer term problem of entitlement spending (Social Security and Medicare), which consumes an increasing portion of the federal budget each year.

So which scenario, bullish or bearish, do you find more compelling? There certainly are valid points on each side of the argument. It won’t surprise you that we will not render an opinion on the short-term direction of the market. Rather than play the loser’s game of guessing where the market is headed over the next quarter or the next year, we remain committed to investing our clients’ capital over multi-year and even multi-decade periods. There will, without doubt, be painful setbacks during these long investment horizons. But the powerful and rising global tides of democracy, capitalism, productivity, and technology will provide great rewards to equity holders with the patience and discipline to weather the short-term turbulence. We are honored to be by our clients’ side for this voyage.

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