Do New All Time Highs Indicate a Top for the Market?
The Dow Jones and S&P 500 finally topped the highs from 2007. Many of our clients have expressed some concern that the market is too expensive, and that now is not a good time to commit new capital to stocks. History is less conclusive. Investors who bought after the market recovered from the 1987 crash would have quadrupled their investment had they stayed invested through the next ten years. Similarly, investors who bought after the market finally surpassed the 1966 peak in 1982 experienced much better than average returns over the next five years.
Richard Sylla, a professor of the history of financial institutions and markets at New York University, is optimistic that the recovery has a ways to go:
“The long periods between new highs — 1929 to 1954, 1968 to 1982, and 2000 to 2007 — were periods marked by both bad economic policies and wars,” Professor Sylla said. “The periods of steady advance — 1954 to 1968 and 1982 to 2000 — featured better economic policies and minor wars. Right now, it seems to me that economic policies are improving, as is the economy as we put the financial crisis behind us, and we are getting out of wars instead of into them, knock on wood. That could indicate that we are in the early stages of a period that might resemble 1954 to 1968 or 1982 to 2000. So the recent new highs could well be a signal that it’s a good time to invest in equities.”
The underlying fundamentals of multi-decade high profit margins, extraordinarily low interest rates, lower than average valuations, and a slow but steady economic recovery suggest that stock prices could move higher. Jeremy J. Siegel, a finance professor at the Wharton School of the University of Pennsylvania and author of the classic “Stocks for the Long Run,” said he agreed that “the data doesn’t bear out that just because the market has hit a new all-time high, it’s too late to buy stocks.”
“I believe that we’re on a very strong bull leg because of market valuations and record low interest rates. The market is selling at about 14 times projected 2013 earnings. That’s below the long-term average over 200 years of about 15. If the market immediately gained 7 to 8 percent, we’d only be at the mean. That gives us plenty of room for further gains. It would have to go up another 30 to 40 percent for there to be the first warning signs. “These are very good times for equity investors, and I think the five-year returns from here will be very good. There’s a lot of skepticism after the worst bear market in 75 years and two serious bear markets in one decade. It’s sobering and it scared a lot of people. That’s not the sign of a market top.”
Weak Recovery Undermines Investor Confidence
Though the market rallied to all-time highs, this bull market has some peculiar features. Rarely have the most defensive sectors like utilities and consumer staple stocks led a bull market. Typically, stocks that are dependent on a growing economy, like industrials and financials take the lead in a new bull market. One explanation is that the early stages of the recovery are much weaker than what we’d expect based on past recoveries.
Normally, housing strongly responds to the lower interest rates that coincide with a recession. But the over-supply and crash in housing was the root cause of this recession. Today, after a modest rebound in housing starts the U.S. is building 30% fewer houses than during the 2001 recession. We’re building half as many houses as we did during the Kennedy administration even though the U.S. has twice as many people.
So, we still have a long way to go to before the confidence of consumers and investors is fully restored. Another possible explanation for the extreme outperformance of the defensive stocks is that low interest rates are forcing bond investors into the stock market. These investors are looking to replace bond income with dividends from stocks. The result is that the valuations of the household name consumer stocks are very high relative to the rest of the market and their historic valuation range.
Growth Stocks and Economically Sensitive Stocks are Cheap Relative to Defensive Stocks
This is the mirror image of stocks that have high future growth expectations. Typically, stocks with better growth prospects trade at a premium to the market, while the defensive, high-dividend paying, low-growth stocks trade at a discount to the market. Today, in many cases, the low growth stocks are trading at a premium to high growth stocks.
According to Seth Masters, Chief investment Officer of Bernstein Global Wealth Management,
“Many stocks with high dividends don’t have growth potential. Their payout is their primary appeal. Utility stocks, for instance, are perceived to have safe dividends. So a lot of people are buying them. Recently they were trading at a 50 percent premium to their historical average valuation. That’s their biggest premium ever. Most utilities are heavily leveraged, strictly regulated and very sensitive to changing energy costs. That doesn’t sound like a safe investment to me. But people perceive them as safe and are giving up some good returns in other places to buy them.”
The Indexes are Over-Exposed to Stocks that are Overvalued
He goes on to suggest that indexes will lag the average stock when the price of high dividend stocks correct,
“Indexes tend to be over-weighted in whatever’s been hot. High-dividend stocks have historically been one-third of the S&P 500 Index. Today they make up 44 percent of that benchmark. We don’t know when the correction in them will be, but it seems to us it will be significant. Meanwhile, many other companies that have been buying back shares instead of paying dividends haven’t been doing so well.”
When you have periods where one particular index is an outlier relative to other segments of the market, the leading index eventually goes into a period of underperformance relative to the broader global stock market. Today, it seems that the S&P 500 index is the recipient of excessive investor enthusiasm. The S&P 500 is the most expensive major index in the world. As investor confidence in the recovery grows, the market rally will likely broaden out and the S&P 500 will hand-off leadership of the rally to the economically sensitive sectors and international markets.
A Static, Buy and Hold Investment Strategy Is Too Inflexible to Succeed if the Economic Landscape is Ever-Changing
One possible catalyst to the rotation in leadership is the relaxation of the Federal Reserve’s bond buying program. The Federal Reserve is buying approximately $85 billion worth of bonds each month. This causes interest rates on all kinds of debt to decrease. It’s the prevailing low interest rates that are forcing bond investors into dividend paying stocks. Once interest rates increase, it seems likely that bond investors will sell out of dividend stocks as they return to the more familiar habitat of the bond market.
Today it seems clear that the growth stock segment of the market is primed to outperform over the next five years. The only question is when the market will recognize the future return discrepancy between safe stocks and growth stocks. We continue to maintain a sizeable allocation to safety stocks, but we have one eye on the exits. Now that the valuations are stretched to historic extremes, it’s not likely that the dominance of the low growth stocks will continue for much longer.
It is a sign of the times that a new all-time high for stocks is thought to be an ominous signal. Markets tend to peak during times of euphoria, which is one of the last words that historians will use to describe our present era. This anxiety is reflected in the high price of stocks that investors perceive to be most safe.
The growth rate of the economy is not yet fast enough to support consistent job creation. This is an impact of the ongoing deleveraging process. As corporations and households focus on reducing spending and paying back debt, consumption and growth remains moderate. But, the fact that the economy continues to grow while debts and deficits decline is very encouraging. At some point, we will move beyond the hard work of reducing debt and growth will accelerate. As the economy improves, investors will reward economically sensitive stocks with higher valuations.
Please feel free to contact me with any questions about our outlook, or how we express our outlook in our individual portfolios.
