Hank Nicholson, CFP® Hank@silverpeakwealth.com
Stocks are enjoying an extended period of rising prices and low volatility. While it is true that stocks might now be slightly overvalued, and that low volatility has led to investor complacency, it is also true that the global economy now finds itself in a period of relative stability and coordinated growth. During such periods, it is common for investment dollars to flow into riskier assets like stocks. And today’s low bond yields are making these riskier assets all the more attractive. Signs of a Short-Term Pullback It has been nearly three years since the stock market’s last decline of 10% or more. The current rally of nearly 80% is the fifth longest historical rally, just behind the period from 1984 to 1987. That said, it is also well short of the longest rally, which was 233% during the 1990s. Near-term volatility, and even a stock market correction, are growing more likely. There are historical trends that hint at a pullback. These include historically subpar performance during mid-cycle election years and seasonally weak performance during the May to October period. But even more troubling for the near-term outlook is elevated level of investor optimism. The NDR Crowd Sentiment Poll, which is an average of many different sentiment indicators, has risen into the “Extreme Optimism” range. This is considered bearish for the market because it is associated with the worst historical returns. Secular Bull Market While the probability of a correction may be on the rise, it is important to remember that the economic conditions that have fueled this bull market are still largely in place—these include low inflation and interest rates, high corporate profits, and relative political and economic stability. Other factors such as employment, confidence, and bank lending are showing improvements. In other words, there are few reasons to believe the bull market that began in 2009 is nearing the end. In fact, leading economic indicators suggest the market’s strength is only reflecting broader economic strength. Strength that is not yet showing any signs of weakening. Overvalued? Yes! The market is overvalued… but not by much. A common way of valuing stocks is to compare the price of the stock (or stocks) to the amount of profits, or earnings, that are generated. This ratio—commonly known as the price-to-earnings (P/E) ratio—is then compared against historical norms. Currently, the forward-looking P/E ratio on the S&P 500 stock index is 15.8. This is only slightly higher than market’s median P/E of 15.1, and a long way from levels that preceded many of the past market bubbles. (This ratio climbed to around 25 during the “Tech Bubble” of the late 1990’s.) Outlook For a variety of reasons, a market pullback seems more probable now than in previous years. However, any drop in share prices is likely to be nothing more than a normal correction in a larger bull market. After the tremendous gains of the last several years, investors should be prepared to give a little back—at least in the short term.