THE 2018 STOCK MARKET: IS IT TOP-HEAVY?
"Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it." -Will Rogers
The 2017 stock market delivered yet again with all the general benchmarks posting stunning gains (S&P 19.4%; DJIA 25.1%; NASDAQ 28.2%). Including dividends, it was the ninth consecutive year of positive returns.1
Ironically, the good news has triggered concerns that a "correction" is in the offing. Armed with foreknowledge, of course, nobody would worry. In top-heavy markets, investors would simply cut back on equities in favor of cash. Once prices re-equilibrated, they'd reverse the trade. Unfortunately, omniscience is a pipe dream. So how can we get a"feel" for where the market is headed? For starters, avoid models that boast an ability to "time" market fluctuations. And forget about precision. In this arena, reliable approximations will suffice. As Graham and Dodd, patron saints of equity investing, put it:
“The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish either that the value is adequate…or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age, or that a man is heavier than he should be without knowing his exact weight.” 2
For eons, analysts have relied on the price-earnings ratio (“P/E”) to evaluate a company’s share price. The ratio is found by dividing a company’s share price by its earnings. For example, a company with $1 per share in earnings that sells for $10would have a P/E of 10. A perspective emerges when the ratio value is interpreted relative to its historical norm. For instance, if our hypothetical company's historical P/E was 10 and all of a sudden spiked to 20, it's a safe bet Wall Street analysts would reassess the stock's prospects. This same logic can be employed when thinking about the overall stock market. Let's take a closer look.
As we've discussed here previously, Gross Domestic Product is a prime determinant of corporate profits, dividends and, in turn, share prices. In a very real sense, then, the stock market is the price of the economy. By substituting the New York StockExchange's market capitalization (aggregate equity shares outstanding multiplied by their respective share price) for “P” in the ratio and GDP for “E,” we can derive the price-economy ratio (“P/Ec”) and determine (at least in a general way) whether the general market is “pricey.” 3
Measured from 1985, the P/Ec ratio has averaged 93%, with two-thirds of the observations ranging between 63% and 123%.4As a statistical matter, then, only about 16% of its historical readings were in "overvalued" territory (i.e., above the light blue band in Figure 2). So how well has P/Ec ratio anticipated top-heavy markets?
A simple simulation lends perspective. Imagine three investors at the close of 1999. One is risk tolerant and simply holds the S&P index. The second investor is risk-averse and elects to roll over Treasury bills rather than accept equity risk. Finally, a third portfolio also holds the S&P but with twist. At the end of each year, the portfolio's Tactical Asset Allocation (TAA) is revisited. Whenever the P/Ec ratio signaled an overvalued market, assets were reallocated to Treasury bills. Otherwise, the TAA portfolio was devoted to the S&P. How did the three portfolio returns compare?
Figure 3 schedules the performance data for each account and confirms the benefit of Tactical Asset Allocation. While there were exceptions, remember that, in this exercise, there's only one way for the TAA fund to earn an excess return over the S&P-- by avoiding market downturns.5 In this regard, notice that the TAA portfolio dodged half the negative markets.6 As a result, the cumulative value of every dollar invested in the strategy grew to $3.77, eclipsing both of the competing portfolios by a healthy margin.
In practice, we recognize each investor’s situation is unique requiring prudent, customized decision making. This hypothetical TAA exercise is an (extreme) example to illustrate the usefulness of focusing on valuation concepts when deploying capital. The bottom line of all this is, in short, investing at any stage of a market cycle is a nerve-wracking decision. On the one hand, the "bull market" is long-in-the-tooth with the P/Ec ratio nudging the upper end of its fair-value range.7 On the other hand, today's tactical decision continues to signal stocks over riskless treasury bills.
In truth, nobody really knows what the sea change now underway in Washington will produce. It's certainly possible that dramatically lower tax rates could spark supernormal economic growth, for instance. So what's the prudent move? Think defense. Ensure emotions are in check and emphasize a well diversified portfolio capable of weathering normal market turbulence. Albeit a knife-edge decision, today's P/Ec ratio suggests that equity risk will be rewarded in the year ahead.
1 Measured from December 31, 2008.
2 Benjamin Graham and David L. Dodd, Security Analysis, McGraw Hill Book Company (1934), p. 18
3 The market capitalization of the New York Stock Exchange may be found at their web site: www.nyse.com. GDP data are available from the Bureau of EconomicAnalysis at http://www.bea.gov.
4 The overvalued and undervalued "bands" shown in Figure 2 were calculated using the P/Ec ratio's mean value and standard deviation figured on a trailing 10-year basis at the close of each calendar year. As a statistical matter, approximately 16% of the observations would exceed the upper (light blue) band.
5 For a detailed discussion of TAA using this technique, see Charles E. Babin & William J. Donovan, "Investing Secrets of the Masters," McGraw-Hill (1999),Chapters 8 & 10.
6 As shown, the TAA portfolio incorrectly targeted the S&P on 3 occasions. Of these, 2011 was a close call. As noted in the table, the portfolio's simulated return was -0.003% versus 0.3% for Treasury bills.
7 See Figure 2 (green marker)
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