The US stock market has run up quite a bit as it looked forward to a lot of promises by the new administration: lower corporate tax rates, $1 trillion in infrastructure spending, and higher economic growth. This has made an already-expensive stock market (one of the most expensive in history even before the election) and a very old one (the 2nd longest in history) even more expensive.
Here’s a look at the valuations for S&P 500 companies going back to the 1970s – they are now the highest in history:
The next graph is a look at how valuations have increased compared to actual earnings. A big problem is that earnings haven’t really moved up too much, while the price investors are willing to pay for those earnings have, which means the stock market run hasn’t been based on very solid ground. Rather, they have spent the past two years counting on a rebound in earnings that have yet to show up. Anything that shakes that confidence could cause prices to fall back in line with earnings, which would be painful:
One reason stocks have continued to go higher is that people have taken out loans to buy more stocks (this is called “margin debt”). Note how margin debt has revisited levels last seen in 2000 and 2007, and we all know how that story unfolded. If history is any guide, future returns may have more risk than reward:
Now let’s look at the bright side. In contrast to the above worries about the market, the main positive that is driving all this is the continued growth in jobs. Here’s the jobs growth chart going back to 1990:
If you’ll allow me to torture some data, I ran a regression to test the relationship between annual jobs growth figures and annual S&P 500 returns going back to 1990. It turns out there’s a pretty decent link between the two. I say I tortured the data because I excluded 2009; that’s the year job loss momentum was still very negative, but once the economic stimulus package was passed in February 2009, the stock market rebounded as investors expected jobs to return quickly, causing an outlier in the data. Here’s the chart showing the relationship between jobs growth and S&P 500 returns:
What we tend to find is that as long as jobs growth is positive, so too are stock market returns, regardless of valuations. That’s not to say that we won’t get dips in the interim. Even with positive jobs growth, we recently had the market fall 10% from September to October 2014, 14% from July to August 2015, and another 14% from November 2015 to January 2016, which is why it always makes sense to have bonds to protect against unexpected large drops in the market. But it’s the continued positive growth in jobs that seems to have a strong ability to help markets bounce back, even if markets are overvalued.
What overvalued markets do is worsen the pain when markets come back to earth. But the key question is, “When does it matter?” The bursting of the dotcom bubble didn’t really start until mid-year 2000, right when jobs numbers started to go negative. The same happened with the housing market bubble in 2007 – the bursting of that bubble didn’t start until we got negative jobs figures in early 2008, and things really fell apart after that.
So the answer to our question would seem to be: “When jobs growth begins to falter.” That’s when it matters, and that’s when you take cover.
Once that figure starts to go negative, that’s when risks to stock market valuations will rise by a lot. And if history is any guide, reducing exposure to stocks and having more investment grade bonds will allow one’s portfolio to better weather the storm.
Bonds are expected to return about 2.5% per year for the next decade, with about 70% lower risk than stocks, while stocks are priced to return about 3.5% per year, so it makes sense to have bonds even in times of rising interest rates because bond prices tend to rise when stocks fall.
The following graph shows why it makes sense to own bonds: it allows you to safely navigate through rough periods in the stock market while giving you the chance to buy stocks at lower prices and valuations.
The following shows how much one’s risk of loss has fallen by adding bonds to a portfolio. More bonds have historically reduced losses in exchange for slightly lower returns:
Given the high valuations for stocks, I think it’s prudent to have more bonds to offset the risk that comes with having a large weighting in stocks.
Speaking of valuations, the stock market’s recent heights puts it at a higher risk of a decline, or at least a greater chance of stopping it in its tracks. Take a look below at the chart of the entire world stock market index. The little graph beneath it is a tool traders often use to figure out where to buy and where to sell stocks. It tells you where to “buy low, sell high” – when it touches the bottom end of the band, it means people are overly pessimistic and it’s a good time to buy, and when it touches the upper band, it means people are a bit too overconfident and it’s a good time to sell. Take a look at the historical points where it has touched the upper and lower bands, and you’ll see that it has proven to be a useful tool. Earlier this month, the stock market touched the upper band, suggesting caution:
Times like this have tended to be good windows to bring stock and bond weights back to neutral levels, just like the last six times these signals happened over the past four years. Please feel free to call or write if I can help answer any questions about the market or your investment portfolio.
Rainier Trinidad, CFA
San Diego and Coronado’s Fiduciary Financial Advisor
Parabolic Asset Management
206 J Avenue
Coronado, CA 92118
Investment Risk Disclaimers: (i) Investments involve risk and are not guaranteed to appreciate, and (ii) Past performance is no guarantee of future results.