That seems to be the question. Since February 24, 2015, the S&P 500 has basically gone sideways with two short-lived downdrafts. The first one was from August 17th to August 25th and the second one was from December 29th to February 11th.
Both were short-lived but nonetheless somewhat hair-raising, pardon the pun. So, the question now becomes…could we be in for more of these “hair-raising” corrections? In our opinion, the answer is “possibly, yes.” We don’t like them any more than you do, but we are basing this simply on sentiment and valuation issues. The S&P 500 is sitting near a critical technical level of 2100, which has been a “ceiling” for this index for a year. Today, investors are wondering if the economic, policy and earnings backdrop has improved enough to provide a springboard for the index to break through this “ceiling” and move higher.
Another question is whether investors should expect more frequent bouts of intense selling pressure and violent swings in market sentiment. In other words, does the volatility we witnessed in the first quarter represent the “new normal,” as the investment management firm PIMCO termed, for market action?
We were not surprised by the pullback in the first quarter, as we have been saying for some time now that valuations in stocks had become stretched (and still are), global growth was decelerating and earnings were contracting. The anticipation of a pullback (we just didn’t know when) is why we rebalanced our portfolios last year and are carrying such a large cash position. In our opinion, the answer to this “new normal” question is “yes.”
Risk assets are going to be highly vulnerable to bad news in a post-debt supercycle world, where growth is depressed, debt levels are still elevated and valuation is less than attractive. And now we have the Fed openly talking about the desire to raise the Federal Funds rate, maybe as early as June. Investors are rightly concerned that any pullback from policy accommodation (in other words, raising rates) could backfire given that U.S. economic growth is far from stellar and that the global economy still suffers from a lack of demand. It is no secret that the Fed has gotten behind “the curve” when it comes to normalizing interest rates.
With 20/20 hindsight, this should have started in mid-2015. As a result, they are now trying to be proactive and get ahead of “the curve.” The Bank Credit Analyst feels that U.S. and global growth will pick up modestly in the second half of the year. This may be one reason why the Fed is openly talking about a potential rate hike this summer. One thing Chair Janet Yellen emphasized is that the Fed is likely to raise interest rates “gradually and cautiously” because raising them too quickly could trigger a downturn to which the Fed may have limited tools to respond.
Valuation and Returns
One of the challenges the Fed will face when they do raise rates is that the dollar will strengthen (putting downward pressure on multinational companies’ earnings) and volatility will increase, creating tighter global financial conditions. This is at a time when global growth remains lackluster. As a result, we believe that a defensive investment posture remains appropriate. Our Investment Committee has long known, from many previous studies, that the best predictor of long-term equity returns is valuation.
I bring it up as a recent research study had some interesting statistics that we wanted to share, so let me summarize it for you. Nobel Laureate Robert Shiller developed what is known as the CAPE ratio. It is the P/E ratio based on the average inflation-adjusted earnings for the last ten years. Going back to 1880, the average CAPE ratio is almost 16 times earnings with a minimum of 5 times (1920) and a maximum of 44 times (late 1999). Currently, we are at 26 times earnings. A low stock market P/E ratio is normally associated with higher future returns, while the reverse is true as well (a higher P/E ratio is associated with lower future returns). Based on Shiller’s historical research, a CAPE ratio between 20 to 30 times earnings equates to future stock returns in the mid-single digits over the next 10 years.
This means that some years’ returns will be greater than the mid-single digits, and some years’ less. We are working very hard to stay above the historical average by using a variety of different instruments, including high(er) dividend paying stock funds, growth and income funds, value funds and tactical asset allocation and market neutral funds, both of which should give us some downside NAV protection when the market has a correction.
Having said the above, what do we expect over the next 6 to 12 months? The stock market is not cheap, the Fed wants to raise interest rates (which helps the dollar but hurts multinationals’ profits), and profit margins are coming down, which means companies will have to “trim” back to keep margins high. In other words, it means cutting back on inventory restocking, reducing employment, keeping wage growth down and still looking for ways to trim “fat” out of the company. And finally, the global markets are still very fragile with respect to their GDP growth prospects.
On the positive side, corporate earnings and GDP are growing, albeit at a very slow pace. GDP growth should, at some point, put a floor under stocks. As long as the Fed raises interest rates only modestly, the market should be able to digest this information and should be able to gradually move higher (emphasis on the word “gradually”).
In closing, let us say that for now we are staying somewhat defensive, conservatively invested and looking for opportunistic investments. We are content, for now, to be overweight cash and underweight equities.
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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.