Market Top or Room to Run?

It feels like we have been asking this question for a few years now.  Every time the market makes new highs, pauses or pulls back slightly every pundit comes out of the woodwork to proclaim the market has topped out or the bull market is over. And yet, the markets just continue to march higher. I have discussed this off and on in some of my commentaries and other blog posts and seem to continually get questions from clients and prospects about this issue. This bull market that started at the end of the financial crisis can’t just keep going, or can it?

Investor Sentiment: One of the many drivers behind most bull markets and one that eventually leads to its demise is investor sentiment.  Famed investor John Templeton once said in regards to investor sentiment “bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” In a note to investors this week, Goldman’s chief US equity strategist David Kostin notes, “investors today are situated between skepticism and optimism,” he continued” because investor euphoria is nonexistent, an imminent start of a long decline seems unlikely.”

Looking back over the past 9 years it is safe to say that much of this axiom has held true but also the pattern doesn’t always happen in a straight line. It is safe to say that most investors are not euphoric about the current markets. However, throughout the current bull market we have gone thru the pessimism stage and then bounced back and forth between the skepticism and optimism stages a number of times, even occasionally touching on euphoria and pessimism sides of the spectrum but never once reaching the euphoric levels that we saw during the tech bubble or the run-up to the financial crisis. If this axiom continues to hold true we will need to see that before a longer term pullback materializes.

It is important to point out though that even without reaching a full euphoric market, short term pull backs of 5 or 10% still are very realistic.  The low volatility environment we are in has made us forget that these types of pullbacks are normal and should be expected.

Valuation: By almost all measures, valuations are quite stretched. Whether these stretched valuations are justified is a discussion for another blog but on the surface, it would seem that most of the market is overvalued.  Looking at the Shiller P/E below, which adjusts for inflation and helps to smooth out the earnings over a longer time frame, you can see that the Shiller PE currently stands at 30.54. That is almost double the long term average of 16.78. Additionally, we have only seen this metric reach this level on two other occasions in history, Black Tuesday just before the market crash of 1929 and during the Dotcom bubble in the late 90s.

Now, just because valuations seem quite high does not mean that the market does not still have room to run or that earnings growth can’t accelerate to justify these current valuations. It also doesn’t mean that the market is at a top. It simply means that historically speaking, the markets are factoring in a much larger earnings multiple than they have in the past. This increased multiple could be a factor of the low interest rate environment we have been in or simply a result of the back looking time frame that this metric uses in its calculation. The earnings number used in the calculation is an average of the previous 10 years of earnings. Which means this includes 2008 and 2009 when earnings dropped almost 90%. If those years are removed or just normalized then the markets still look stretched but the valuation situation doesn’t look nearly as dire.

Economic Data: From a fundamental standpoint the economy is running strong.  GDP for last quarter was recently revised up to 3%. Monthly job growth has averaged around 175,000 leading to one of the lowest unemployment rates in history. Even with this record low unemployment, the number of job openings in the US currently sits at an all-time high meaning the employment situation in this country looks like it will continue to be strong. Wages have been growing at around 2.7% and consumer confidence is also at its highest level since 2001.

With all of this positive economic data, it seems difficult to imagine that a recession is imminent. It is important to point out that market performance is not directly correlated to economic performance, but a relative correlation does exist.  This positive economic data won’t prevent a short term market pull back but could help buffer any longer term pullback and does create a great foundation for companies to continue to grow.

Uncertain Factors: There are other variables in the market that could also signal the end to this bull-run or at least slam on its breaks. I often discuss the many uncertainties in the market, especially around tail risk events.  These risks are not being fully priced into the markets and should one occur could lead to a major sell-off as people flee to safer assets.

On the flip side, other uncertain events could do the opposite and just add fuel to this market pushing it thru the optimistic stage.  If tax reform or regulatory reform becomes more of a certainty over the coming months than we could see a sharp leg up in the markets.  The general consensus is that we are far from any real legislation but such a positive surprise could add to investor optimism leading us closer to a market top. However, this would only be after a move higher.

So where does this leave us now? Investor sentiment and economic fundamentals are pointing to a continued run of the bulls.  Valuations and geopolitical risks are implying that we should proceed with caution. The real answer is to make sure you are positioned somewhere in the middle.  During these times a balanced portfolio can be your best friend.  It is also important to avoid panic selling if the market does correct at all. As we have seen recently these pullbacks will happen but the markets have been resilient.  If we do see a more pronounced correction of 10% just remember that these types of corrections are normal. If you can’t stomach a decline like that then you shouldn’t be as highly as invested as you are. You should reduce your equity exposure to a more comfortable risk tolerance.

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