As Stocks Continue to Go Up and Up, We Might Be Due for a Correction — or Worse

[10/22/17]  Markets are never perfect.

Yet for the last eight-and-a-half years, they’ve been rather magnificent. The benchmark S&P 500 Index has jumped 19% over the past 12 months, 30% over the past three years and a whopping 93% since 2009.

The Nasdaq recently called this perpetual march to new highs the never-ending bull market. Fund managers have been milking it while the short-seller Jim Chanos admitted to CNBC last month that spotting overvalued stocks has been easy; it’s making money on them that’s become difficult.

If and when the bull market might end is anyone’s guess. What’s not in dispute is that stocks are trading near their highest valuations since early 2009. The peak came in March when the S&P 500 was trading at 22.03 times trailing 12-month earnings. Immediately afterward, valuations slipped a bit but then came roaring back to 21.9 times earnings as of Friday Oct. 20.

The S&P 500 has gained 8.1% since April 1.

“Valuations are very high,” said Richard Sylla, a professor emeritus of economics at New York University Stern School of Business, who said he keeps a close watch on the more complex Shiller CAPE PE Ratio. “That’s the kind of flashing light warning signal that says we’re in territories where valuations are extremely high.”

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The Shiller PE Ratio, Sylla pointed out, is trading at its third highest level in history, a valuation topped only by the period just before the Crash of 1929, and immediately prior to the bursting of the dot-com bubble in 1999-2000, which sparked a 75% decline of the tech-heavy Nasdaq over the ensuing two years.

On the 30th anniversary of the ignominious Crash of 1987, it bears remembering how and why corrections form and whether the current conditions might trigger a market decline of more than 10% from a 52-week high, the actual definition of a correction. While it’s true that corrections have occurred in recent years — the fall of 2015, for instance — equity markets quickly recovered within a few months, more than offsetting such declines.

Today’s long bull market is the product of many factors. Low interest rates, of course, are high among them. If cash can be obtained for next to nothing, and the market keeps surging, common sense says investors and corporations will keep borrowing and keep buying equities. The mainstreaming of exchange-traded-fund (ETFs) is another factor, according to Sylla. Investment firms are increasingly selling ETFs that require them to buy certain stocks to replicate a basket of equities.

“Indexing is really passive investing,” he said. “People who start index funds or ETFs just have to buy what’s out there whether it’s high-priced or not, and that’s been pushing the market up fairly steadily.”

But can this last? Federal Reserve Chairman Janet Yellen has signaled she’s likely in the coming months to continue to gradually raise rates, moves that could make it harder for companies to pay dividends and buy back shares. According to Bloomberg Intelligence, roughly 30% of the gains in the S&P 500 from the third quarter of 2009 to the end of 2016 were sustained by share buybacks.

Corporations, therefore, have been using profits to increase equity values, rather than to boost wages or invest in their own operations. But that’s a subject for another time.

So what might trigger a correction?

Michael J. Wilson, Morgan Stanley’s chief equity strategist, pointed this week to a confluence of potential factors while observing that cyclical stocks have performed better of late, an affirmation of a growing economy. If recent previous quarters are any guide, Wilson says stocks are likely to rally over the next few weeks in anticipation of third-quarter earnings, and then decline as those numbers become public.

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A slip in equity prices could accelerate, he adds, as the Fed reduces its balance sheet for the first time since it began buying mortgage-backed securities in late 2008. Markets may also react badly if Republicans are unable to pass a tax reform package, while uncertainty over a new Fed chair could also spook investors.

Another factor to consider is the domino effect. Back in 1997, international markets were thrown into turmoil by the collapse of the Thai baht after the government ran out of enough foreign currency to support its peg to the U.S. dollar. The “Asian flu” promptly sent the Dow Jones Industrial Average plummeting by 7.2%. Emerging markets have been strong performers in 2017, but they too have been labeled as overvalued.

Regulation is another issue. Some seven years after Ronald Reagan was elected president and then again roughly the same amount of time after George W. Bush was elected president, the New York Stock Exchange suffered a massive blow, dropping by more than 20%. Deregulation often means regulators give banks and financial institutions leeway under the assumption that markets perform best without oversight.

President Donald Trump has made clear his disdain for Sarbanes-Oxley as well as Dodd-Frank, two landmark regulatory frameworks meant to safeguard financial institutions, and by extension, the savings and stock-based pensions of millions of Americans.

For the moment, corporate earnings have been solid, though Sylla underscores that historically speaking, earnings are at a high level relative to GDP, and that spread typically that reverts to a mean. In other words, the party won’t go on forever.

As any investor over the age of 20 knows, major market corrections have become more frequent in recent decades. And no fund manager or economist wants to be accused of having worn rose-colored glasses as disaster struck, again. Isn’t that right, Mr. Greenspan?


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