Investors are breathing easy once again. The 6% decline in U.S. equities from mid-January to early February was quickly erased with a straight up rally reminiscent of 2013 (see chart below).
With new all-time highs in place, it is a good time to reflect on where we are currently and where we may be headed.
First, on the valuation front, U.S. equities are anything but cheap. While those in the permanently bullish camp may say otherwise, the evidence from any valuation metric that has predictive value is clear. The Shiller P/E ratio, currently at 25.1, is higher than 91% of other time periods. While admittedly not a short-term indicator (the market can certainly get more overvalued before underperforming), it is one of the best predictors of long-term returns (7-10 years out).
In the chart below, you’ll notice that the current ratio is within spitting distance of the 2007 peak valuation level. A mere 10% advance in the S&P 500 from current levels would surpass those levels, and the only remaining comparative periods at that point would be 1929 and 1997 through early 2002. To be expecting a major advance this year, then, you are implicitly relying on the creation of another bubble. While this could certainly occur it should not be your base case scenario.
Next, in looking at the economic cycle, the U.S. economy will hit five years (60 months) into the expansion this June. According to the National Bureau of Economic Research (NBER), the average expansion historically is 38 months. Since World War II, the average expansion has been longer at 58 months. We are therefore long in the tooth of this expansion. That is not to say that this won’t be an above average expansion, just that we are more likely to be closer to the end of the cycle than the beginning. This is important as the most severe and lengthy Bear Markets historically are associated with a recession.
Finally, in looking at the market cycle, the Bull Market that began in March 2009 will reach five years this March with a total advance in the S&P 500 (SPY) currently at 179%. This is well above the historical average in terms of length and magnitude for the typical Bull Market. Needless to say, we are long in the tooth here as well.
So that’s where we stand today.
As far as where we are headed, in the short-run the market trades not on valuation but on momentum and sentiment. Both factors still point to further gains in the near term as momentum remains strong and the positive feedback loop from successful buying of the dip remains in place. Of course, this could change quickly and I would continue to advise investors to be more focused on risk management this year.
In the long-run, though, the picture is quite different. The above factors are likely to lead to significant underperformance over the next 7-10 years. While that may seem like an eternity for many, the most successful long-term asset allocators are operating in this time frame.
What is the average investor likely to be doing at this stage of the Bull Market? I think the words of a former Citigroup CEO sum that up nicely: they’re “still dancing.”
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” – Chuck Prince, Citigroup CEO, July 2007
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