The equity rally, now at 2065 on the S&P as of April 29th, is meeting some resistance just above this level. This does not mean that the S&P 500 can’t go above its all-time high of 2133, but it does mean that it will require significant buying to power it through this all-time high.
While this is certainly not impossible it means that the market will have to “look beyond” the current headwinds of high valuations, financial stock vulnerability, future earnings outlooks (not looking good at this point) and the broad top in major indices that began a year ago. While we are not saying that these headwinds will stop the equity market (S&P 500) from going higher, let’s look at what is a big driver of these headwinds: the dollar, the Fed and oil prices. Currently, the dollar has shown some weakness versus other currencies so this makes it easier for our multi-national companies to be more price competitive on a global basis with respect to selling their products.
If the dollar were to strengthen then it would hurt their ability to compete price wise with other countries in selling their products. However, if the dollar were to weaken even more, as it has done lately, then that would help them sell more products abroad, thus helping their bottom line.
The Fed could be an enabler or a headwind to the markets depending on what it does with interest rates. If the Fed raises interest rates then that would produce a stronger dollar as more money from abroad would come to our shores and buy Treasuries. As stated before, this would strengthen the dollar thus making our exports more expensive to foreigners, further putting downward pressure on their earnings. However, if the Fed backs off of multiple rate increases this year this should do two things: keep the dollar somewhat weaker thus making our exports more affordable to foreigners, and give investors the comfort of knowing that the Fed is not going to necessarily take away “the punch bowl.”
While not raising rates this year is a possibility, the market continuing to rise is not sustainable without some kind of correction. In other words, if the Fed continues raising rates, earnings of multi-national companies will take a hit, thus driving valuations (i.e., P/E ratios) higher. If the Fed takes a breather from raising rates and the markets continue to move higher WITHOUT a corresponding increase in corporate earnings, valuations will get higher (just like they did in 1999 - early 2000). We are NOT suggesting that 1999 - early 2000 is about to repeat itself as the dynamics and financials of corporate America are much stronger today, but the markets can only go so high before we have a correction.
At this point, with the data points we have (always subject to revision), we do not see a major bear market around the corner. HOWEVER, there is currently more investor optimism about the markets in the short term, which is a bit troubling to us. Our thinking is that there is a small (23%) probability that the Fed will raise interest rates in June, and while that probability does increase for the remainder of the year (49% in September and 71% in December), nothing is certain. We know the Fed wants to raise rates but is data dependent on not only what is happening here but also abroad. While the U.S. is doing better than many parts of the world it is still pretty muted. Stay tuned…
Currently, we believe that we are in the “higher risk” area for equities. As a result, we are comfortable carrying a higher than normal cash or money market fund position for now. There will be a time to reduce our cash position significantly, but we don’t think it is right now. To put this all in perspective, one of the many metrics we look at is the P/E ratio (price divided by earnings). As we have noted many times in the past, the median P/E ratio on a trailing 12 month basis has been 15.5 times earnings going back some 50 years. Currently, the trailing P/E ratio is approximately 21 times earnings, with the forward looking 12 month P/E ratio a little over 20 times earnings.
It is easy to see that the market is not cheap or even reasonably priced. It doesn’t mean that the S&P 500 can’t go higher, which concerns us due to valuations and is why we are carrying a larger than normal cash position. This position is enough for many months of cash distributions if the market were to correct. As said above, we don’t like carrying such a high cash position as it hurts our performance in a rising market, but we feel that it is the prudent thing to do at this time.
Before closing, let me end with a couple of thoughts from the Investment Policy Committee (IPC) which just concluded its quarterly meeting. The IPC agreed to increase its value weighting over its growth weighting by several percentage points now, and possibly several more points in the near future. We reviewed a manager who has been on our watch list for under-performance over 6 of the last 9 quarters and asked the investment department to make a recommendation. The department will discuss this further in detail and either replace this manager or hold onto it for another quarter as their performance of late has picked up.
Finally, the investment department recommended to the IPC that we move a small percentage from our overweight cash position to one of our intermediate bond managers to help increase our current yield going forward.
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.