What a difference a year makes. This time last year, the market was on the cusp of a correction. The S&P returned -6.8% in October 2018 and -9.0% in December 2018. We kissed the bear for about 10 minutes on December 24th by which time the market had officially lost 20% of its value since its September 21st high. The long overdue bear market, it seemed, had finally arrived.
Many clients and market commentators at the time were predicting a horrible 2019. Clients anxiously questioned if they should move to cash “to wait it out.” We know the evidence suggests otherwise that the average annualized return is about 10% after a market decline and we counseled our clients to stay the course.
Fast forward twelve months. Today, the 2018 Q4 market correction has been all but erased from our collective memory. On Friday, November 8th the S&P 500 Index hit an all-time high of 3,093. The US large cap stock index was up over 23% for the year through October 31st; our flagship US Large Cap multifactor SMA, PMC’s US Large Cap VMQ strategy, returned 26% YTD through the same period. It’s always nice to see when our advice pays big dividends, especially within such a short period of time.
Our clients are now asking whether or not they should take some gains off the table. The answer to that is both yes and no. If the question is whether or not they should rebalance their portfolios to remain properly diversified, then the answer is a resounding “Yes!”. But if they’re asking whether or not they should move to cash or out of US stocks given market highs, then the answer is “absolutely not.” Clients should remain invested in a globally diversified portfolios and that naturally means they should continue to own their US equities, despite new market highs. Market returns after market highs over subsequent 1, 3, and 5-year horizons are quite attractive. It goes without saying that clients should remain fully invested, so long as they’re properly diversified.
But what are the prospects for US stocks over the next 12 months? This is always a hard question to answer. Predicting stock prices over such a short-term horizon is an exercise in futility since short-term returns are notoriously noisy. We know that. But that said, let’s look at a two key metrics that I think might be telling—forecasted earnings growth and valuations.
First, let’s look at valuations. By any objective measure, stocks are not at all-time highs on a valuation adjusted basis. That milestone was achieved in the late 1990s when the S&P was trading at 25 times forecasted earnings. Today, the S&P 500 is trading at a more modest 17.5 times next year’s earnings, about 8% higher than its 25-year average of about 16.2 times earnings but still well south of where it stood during the heyday of the late 1990s. This equates to a current earnings yield of 5.7% ($1 of earnings/index price). For context, in the 1990s, stocks traded on average at about the same multiple as they do today (about 17-18 times forward earnings). That’s an earnings yield in the 1990s that was about the same as it is today, about 5.7%. But what’s different is that in the 1990s the 2-year treasury rate yielded 5.75% on average. Today, the 2-year is yielding only 1.68%, yet stocks are yielding the same.
Second, let’s consider earnings. Along with interest rates, earnings are the most important ingredient in determining stock prices. So what does next year’s earnings growth look like? According to FactSet’s Earnings Insight, analysts collectively project earnings growth of 9.7% in 2020 for S&P 500 companies. If that projection comes to fruition, that’s pretty solid earnings growth.
So what’s the takeaway for clients? Remain globally diversified and don’t try to time to the market. The best time to invest is when you have the money and the best time to sell is when you need the money; the worst time to buy or sell is when you think you can predict future returns based on current returns.
Jun 8, 2018
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