Over the last several weeks, much attention has shifted to the S&P 500 index as it reached and eclipsed new highs. For some investors, this was a non-event - after all, it’s a normal occurrence historically within bull markets for the S&P 500 to reach new highs (click on the chart for a larger version):
Stock Market Price Return Since 1900
Source: FactSet, J.P. Morgan Asset Management. Data shown in log scale to best illustrate long-term index patterns. P/E ratios shown at price peaks and troughs use trailing four quarters of reported earnings and are shown as a one year average. Past performance is not indicative of future returns. Chart is for illustrative purposes only. Data are as of 6/30/13.
For others, however, the S&P 500’s run up is a cause for concern. Investors wonder if “what goes up must come down” and whether the S&P 500’s gain to recent levels is a sign the market is overpriced. A glance at JP Morgan’s chart of the S&P 500 since 1997 illustrates why this might be a concern (click on the chart for a larger version):
Source: Standard & Poor’s, First Call, Compustat, FactSet, J.P. Morgan Asset Management. Dividend yield is calculated as the annualized dividend rate divided by price, as provided by Compustat. Forward Price to earnings Ratio is a bottom-up calculation based on the most recent S&P 500 Index price, divided by consensus estimates for earnings in the next 12 months (NTM), and is provided by FactSet Market Aggregates. Returns are cumulative and based on S&P 500 Index price movement only, and do not include the reinvestment of dividends. Past performance is not indicative of future returns. Data are as of 6/30/13.
With the market now recovered from the events of 2008 and reaching all-time highs, we’ve seen many investors asking what they should do with their investments. Many investors wonder: Should I go defensive in my portfolio? Is the stock market at all-time highs? Or is the market poised to go higher?
The last few weeks have seen developments that could stir the markets, including the tensions in the Middle East, specifically Syria. Uncertainty can have an effect on the markets and while our outlook remains positive, we would not be surprised to see a stock market correction. As we wrote before, these are normal in healthy markets.
There are a couple of points to consider before making any tactical moves in your portfolio.
In a May 2013 report by MKM Partners LLC’s chief economist and chief market strategist, Michael T. Darda, he states that “the S&P 500 has yet to surpass its two previous peaks on an inflation-adjusted basis even after setting records in the past six weeks.”1 In other words, the S&P 500 may have reached new highs on a numbers basis, but it hasn’t in dollar terms.
This is important, because the inflation-adjusted level of the S&P 500 provides us a context for how the index is priced in today’s dollars. Think of it this way: $1,000 in 1985 would not buy you the same amount of goods today. The number becomes less relevant if you don’t adjust its value for inflation, which is what Mr. Darda does in his study. He points out that the real, inflation-adjusted record for the S&P 500 was actually reached in March 2000, and the S&P 500 would need to rise 28% (from its May 8, 2013 level) to reach that mark in the current cycle.1
(click on the chart for a larger version)
Source: St. Louis Federal Reserve
When the fundamentals of the economy and the stock market are healthy, rising corporate profits should support a rising stock market, and the two generally move in tandem. In the above chart, you can see that throughout most of the 1990’s this was the case.
However, in the late 90’s, the market started to rise irrationally and well ahead of corporate profits. The chart shows that the stock market’s rapid ascent in the late 90’s wasn’t supported by rising corporate profits (a basic fundamental), and the Tech Bubble formed. Once the bubble burst, the bear market of 2000-2002 followed.
In today’s environment, the opposite is occurring. Taking a look at the last few years on the chart, you can see that corporate profit growth has widely exceeded gains in the S&P 500 index. Indeed, according to Bloomberg, “profits at American companies have surged 20 percent a year since 2009, twice as fast as during the dot-com advance.”2 Yet, in this cycle, the stock market hasn’t kept pace.
In order for the gap between corporate profits and the S&P 500 to narrow, either corporate profits would need to fall substantially, or the stock market could rise from here. A recent report by Thomson Reuters indicates that second quarter earnings growth of S&P 500 companies is expected to be 4.5%, a solid growth rate.
An investor looking at the first chart in this newsletter might conclude that the market is going to tip over into a bear market, and may choose to go defensive in their portfolio. Or the market could continue to reach new highs, for months or perhaps even years to come. We believe crafting a well-diversified portfolio is important in both environments.
It’s important to remember that how you position your portfolio first depends on your long-term goals and your unique financial situation. In our view, a properly diversified portfolio should be based on an investor’s goals and also be strategically positioned for a variety of market outcomes. In a recent piece we wrote titled, “2 Important Steps to Diversifying Your Portfolio,” we discuss how to approach portfolio strategy using diversification of asset classes while also diversifying across money managers.
There are also money manager strategies designed to participate in rising market environments, while attempting to limit losses in portfolios during prolonged market downturns. Investors may want to consider including strategies such as these as part of a well-diversified portfolio.
If you have any questions or would like to discuss your portfolio or investment plan, please give one of our Wealth Managers a call at (800) 541-7774.
Seton is a CERTIFIED FINANCIAL PLANNERTM professional and Vice President of Investments at WrapManager, Inc.
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