“After making several attempts to break through the psychologically important 1700 level, the S&P 500 ended the week down about 0.1%. This is the first week since mid-June that the S&P 500 declined. While I do not feel that the market is set for a large decline and see any substantial pullback as a long-term buying opportunity, I am expecting some degree of selling in the short-term. The reason is very simple. Although I expect the economy to accelerate in the second half of the year, the second quarter is looking relatively weak. Additionally, top-line revenue growth for the companies within the S&P 500 is looking more and more elusive and earnings growth is lackluster.
Instead of being driven by earnings, the market is rising because P/E multiples are expanding. At the beginning of the year, the S&P 500 had a P/E multiple, based on expected 2013 earnings, of 13.8. As of the end of July, the forward P/E multiple of the S&P 500 is 15.7 times projected earnings estimates. Effectively, P/E valuation multiples have expanded by 13.7% so far this year. As of July 26th, the S&P 500 is up 19.9%, or 18.8% if you exclude dividends. This means that the majority of the market’s gain can be attributed to stocks becoming more expensive, not underlying earnings growth.
P/E multiples have expanded for two reasons. First, you have to remember that at the end of last year the market was still pricing in a material chance of a Eurozone collapse and numerous other macro-economic risks. Fast forward seven months, and while there have not been many positive developments for stocks, the market was not pricing in something good happening, it was pricing in some truly horrendous scenarios. When these events did not materialize, the market went up. Secondly, the unprecedented quantitative easing, which effectively amounts to printing money by the Federal Reserve, is pushing the value of all risky assets up, including stocks and real estate. Bernanke has been gambling that if asset prices rise, everyone will become wealthier, consumers will buy more goods and corporations will then potentially hire more people. GM’s recent earnings report is evidence that the plan is working.
The problem is that although corporate earnings in aggregate can grow almost indefinitely, valuations are constrained. Thirty years from now, there is no reason that aggregate corporate earnings could not be triple their current levels. However, I can almost guarantee that in 2043 the P/E multiple of the S&P 500 will not be triple its current level. Long-term market gains must therefore be driven by earnings growth – there is no other way that the market can sustainably appreciate over time. Changes in P/E levels will cause violent moves in the market, such as we have seen this year, but such moves are not sustainable over long periods of time. Today, my concern for the market boils down to the fact that it is very unlikely P/E multiples will continue to expand at the rate they have in the first half of the year. Right now the market is already pricing in an economic recovery. Therefore, GDP growth would need to surprise to the upside in order for the P/E multiple to continue to increase.
My biggest concern for the coming week is the second quarter GDP growth report that is due out on Wednesday. The consensus estimate for year-over-year GDP growth has fallen to around 0.9%. I expect the actual number will be even lower, and would not be surprised to see GDP growth materialize around 0.5%. Furthermore, the recent reading on shipments of nondefense capital goods for June came in this past week much lighter than expected; and, despite home prices trending up, I expect the volume of home sales will slow due to the recent uptick in mortgage rates.
So, do I recommend that investors sell out of stocks and wait for the Wednesday GDP number? Absolutely not! For one, if the GDP number is in fact as weak as I anticipate, it is possible that the market might actually rally as it will be an indication that the Federal Reserve will keep its printing press running at full speed. If the S&P 500 then pushes through the 1700 ceiling, I would expect some continued momentum. Additionally, a slew of earnings reports are due this week and if we see a few key companies report positive earnings surprises, the market could easily push higher.
As a rule of thumb, you never want to try to time the market. Worse than incorrectly timing the market, there is a chance you will be correct a couple of times. Such success would give you an inflated and inaccurate sense of your market timing ability. No matter what you think, the ability to time the market does not exist. In all my years I have never met anyone who has successfully timed the market multiple times. Much like Captain Ahab, pursuing the white whale of market timing only leads to one’s destruction. The best course of action is to realize that stocks trend up over long periods of time, and then bet on this trend regardless of where you personally believe the market is heading. Much like a pilot in a storm who knows to trust their instruments, a professional investor realizes that as important as intuition is, it is more important to go with the base rate and gamble that the market will continue to trend up over time as it has historically.
That being said, I can’t help but feel that we are due for some selling in the market. Interest rates are going to be rising and inflation will begin to accelerate once unemployment starts to come down. The current pullback of yields off their highs should be used as an opportunity to re-evaluate your fixed income exposure. Ten years from now, interest rates are going to be substantially higher than they are now. Those who tilt towards equities will likely do nicely, while those that hold on to long duration bonds stand the distinct possibility of being cooked like a frog in a saucepan – very gradually”.
About Mitch Zacks
Mitch is a Senior Portfolio Manager at Zacks Investment Management. He wrote a weekly column for the Chicago Sun-Times and has published two books on quantitative investment strategies. He has a B.A. in Economics from Yale University and an M.B.A. in Analytic Finance from the University of Chicago.
Disclosure: This communication is for informational purposes only and nothing herein should be construed as a solicitation, recommendation or an offer to buy or sell any securities or product, and does not constitute legal or tax advice. The information contained herein has been obtained from sources believed to be reliable but we do not guarantee accuracy or completeness. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional investment, legal, tax, or accounting counsel.
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