The above was the headline from the October 10, 2016 research report from the Bank Credit Analyst (BCA). However, you would never know it from where the stock market is currently trading.
As we’ve quoted before, a wise investor once said that in the short term the market is a voting machine, but in the long term it is a weighing machine. Translation: in the short term the market can get over or undervalued depending upon the sentiment of investors, but in the long run the market weighs the evidence (corporate earnings, GDP, interest rates, etc.) to decide where the market should be trading.
Consider the time period of the late 1970s to early 1982 when the S&P 500 traded between 109 and 118. That was because of the lingering negative sentiment from the Arab oil embargo and very high interest rates. Finally, in mid- 1982, the market considered the evidence and realized that things going forward were not that bad, and went on to have one of its greatest bull runs of the century. The same goes for the time period in the late 1990s when investors just couldn’t own enough stocks. When the evidence was finally weighed in (early 2000), the NASDAQ went from over 5000 to a bottom of 1100 +/- and the S&P 500 was nearly cut in half.
The point is that the stock market can, in the short term, get overpriced or underpriced. Fast forward to today when there seems to be somewhat of a disconnect between stock prices and earnings. Through the second quarter of this year, if you take where the S&P 500 was trading on October 31, 2016 (2126) and divide it by the last four quarters of KNOWN earnings, we are trading at approximately 22 times the P/E multiple. If you look at 2016, which includes the third and fourth quarters of UNKNOWN earnings, we are trading at approximately 21 times the multiple. Remember that the median, somewhat akin to the average, for the last 30+ years is just under 16 times earnings.
With this in mind, one could conclude that the market is overvalued, whether it be slightly or grossly overvalued is anyone’s guess. We are taking the position that it is just overvalued. As a result, we have positioned our portfolios in a more defensive posture without getting out of the market altogether or trying to “time” the market (a fool’s game, in our opinion). There is a saying in this business that at some point in time most things “revert back to the mean,” which means that something that is overvalued can become fairly valued or even undervalued over time. The reverse is true as well. We saw this in the late 1990s and again in late 2007-2008.
Earnings and Prices
Let us be perfectly clear, we are not saying that anything dramatic is about to happen, but rather that at some point in time, earnings and prices need to come “closer” to one another so valuations make more sense. This can happen several ways. The obvious way is for prices to regress or sell off and make prices and earnings more in line with one another. This is the painful way. Another way is for prices to stay range-bound to give earnings time to “catch up,” thus bringing valuations more in line with the longer-term average.
From our vantage point, we feel that prices are staying elevated due to the easy money policy that the Fed has had in place since 2008. Even though the market knows or feels that interest rates are probably going higher, but at a very slow pace, the market seems to be shrugging that off for now as the S&P 500 continues to trade sideways, as it has since July of last year.
Earlier I mentioned that our portfolios are somewhat defensively postured. We do this, when appropriate, by determining which managers we want to use after analyzing a number of metrics and statistics. Two of the statistics we pay very close attention to are the upside and downside capture ratios. Ideally, you would like to find an equity manager whose fund goes up more than the S&P 500 when times are good and goes down less than the S&P 500 when times are more challenging. Regrettably, they are few and far between, if they even exist.
Usually when a manager does better than the Index in good markets, he does poorly against the Index when the market goes down. As a result, having our portfolios defensively postured is saying that we have some managers who don’t do quite as well as the Index in good times but do much better than the Index in down markets. These are usually, but not always, value managers. Then we have several managers who do just the opposite, and they are more growth-oriented managers.
As a firm that is almost 30 years old, we have had a tendency to be more value-oriented. However, when we have felt the time was appropriate, we have been slightly more growth-oriented. Today, we are approximately 58% value-oriented and 42% growth-oriented. We pay close attention to this asset allocation mix to determine if this is where we want to be for the next three to nine months. Sometimes, adjusting this ratio is in order.
In closing, let me repeat what I said in last month’s newsletter that in the long run, politics or political elections will not determine the outcome of the stock market...earnings will. It is important to recognize that it is rare for earnings and GDP to diverge much. After all, both are adequate measures of the business cycle and, while there have been a few times since the 1950s when they have negatively diverged over time, they have always gotten back in sync. What is good for business is good for the economy at large.
Please contact us at (972) 684-5923 if you have any questions.
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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security.