News & Insights
Over The Top
After weeks of timidly approaching a record, the S&P 500 closed out the 1stquarter above the all-time high achieved in October of 2007. We modestly note that we gave a good chance to this outcome in the last quarterly comment, but remain skeptical about anyone’s ability (especially our own) to predict short-term market fluctuations. Having surpassed the all-time high, the obvious question is whether this event is significant and whether or not recent performance is likely to be repeated. Achieving such a landmark is notable and with investor sentiment improving, it is not hard to give at least a fair chance for the stock market’s continued rise in 2013.
The less obvious and perhaps more important question is whether a reasonable estimate of future long-term returns from the stock market justifies taking an aggressive stance. We think not. From the current high water mark, future long-term returns will be modest. Our mildly cautious stance rests on three main points: 1. The market is fully valued on several measures 2. This extended good earnings cycle is likely to be peaking and 3. An accommodative Federal Reserve is likely to reduce the level of support provided to the financial markets within the next 1 to 2 years.
Robert Schiller of Yale is a respected keeper of some of the ideas put forward by the great investor Benjamin Graham (Warren Buffet’s mentor). An important one is the cyclical or smoothed price to earnings ratio sometimes called Schiller’s P/E, based on the average of 10 years trailing earnings. Historically, Schiller’s P/E has averaged around 15 and is currently above 23. Certainly by other metrics we trust, the market looks more reasonably priced, but to us the S&P 500 is no bargain.
Profits continue to improve from the recession, but at a decelerating pace. In 2012, profits amounted to 11% of US GDP compared to a long-term average of 6.22% according to the Department of Commerce. Profits tend to revert to their mean over time and so it is hard to see how profits climb much further relative to GDP.
We enthusiastically embrace the improvement in the price investors are willing to pay for stocks and the record profitability of U.S. corporations. However we should not just extrapolate the recent past into the next several years. Since 2008, the Federal Reserve has provided asset markets a boost of unprecedented size. The central bank’s hand is responsible for a portion of the market’s performance and so we have to take its eventual policy exit into account.
The fundamentals suggest to us a stock market that should either mark time around current levels or decline a bit as it adjusts to a moderating profit cycle and rising rates but improving investor sentiment and decent news on the economy could take us a little higher. We believe our emphasis of financially strong high quality stocks is particularly well suited to the environment that will unfold over the next several quarters. If the market rises another 10% or so this year, a more defensive posture may be appropriate.
The Altavista Investment Team – Spring 2013