Back on June 4th, in my commentary suggesting Yogi Berra (“When you come to a fork in the road, take it!”) would make a great investment strategist I thought at the time we were indeed at a fork in the road. If interest rates went higher (very unlikely back then) the market would go to the dogs, but if they didn’t I noted: ‘If financial turmoil continues unabated and rates remain extremely low, things could go very well for the stock markets, especially if earnings growth were to surprise on the upside….’
How well could things go? My back-of-the-envelope analysis pegged the S&P500 heading to the 2000 level (roughly 50% HIGHER than June 4th level) should rates remain steady. You may recall I did this because there were so many blogs and media articles recommending the market was overvalued and overbought (tripe).
I followed up in July with “When to rotate into cyclicals? NOW!” when it was clear analysts were beginning to succumb to groupthink (also see chart in previous posting) and revise down estimates like there was no tomorrow. Rates remained low as the mood deteriorated and therefore things did go “very well for the stock market.” Since June 4th the S&P 500 Index (1278.18) has climbed 11.8% (to 1428.50 last I looked) – not bad for only 4 months.
This from The Wall Street Journal on Friday (Oct. 12th):
“In late-afternoon trading, the benchmark 10-year note was 4/32 higher in price to yield 1.661%. The 30-year bond was 14/32 higher to yield 2.834%. Bond prices move inversely to yields.”
Are the bonds back in town? As you can see from the chart, bonds have been in a trading range while equities were strengthening, and remain so. I know experts (hello there Art…you reading this?) who specialize in trading bonds in markets like these. For the rest of us, there’s no money to be made in fixed income other than the coupon if you hold it to maturity. But what about stocks? Have they run their course?
In my previous commentary (posted just prior to the recent weakness), I recommended it would be wisest to avoid stocks and sit on cash while institutional investors do their year-end window dressing. Generally this means really BIG funds trimming stocks that have appreciated too much, since their portfolio weighting has increased disproportionately. They will also try to sell ’embarassing’ stocks so they don’t show up in year-end statements to their clients.
After 20 years of watching the phenomenon (and doing it myself) – which in my opinion accounts for a great deal of the market turbulence we always encounter during the 4th quarter of any year – I’ve learned not to ignore it. But is there upside to the market once we get through the turbulence?
Keep it simple! Using my proprietary valuation model (okay, it’s just back-of-the-envelope again) I quesstimate the S&P could move to levels in the below table, assuming no change in underlying earnings, and depending upon what happens to the general level of interest rates which affects investors’ discount rate:
The stock market would appear to be fully valued right now, if the appropriate discount rate is 6%. But as noted above, with the long term bond yield down around the 3% level why use such an aggressive discount rate? That’s the million dollar question isn’t it?
For what it’s worth, my experience teaches me that even “if” 3% is where long term Treasuries should be, investor expectations tend to be erratic. Since it is widely known that governments have worked furiously to depress interest rates, what happens when they pop a bit? Don’t be surprised then if the discount rate investors implicitly use to value the stock market also shoots up to 7% or higher over the next month or two. A correction (downside) will hurt stocks even if it is a short-lived one. Also, don’t forget window dressing.
The good news is that earnings will continue to improve, yet modest (if any) growth in China and Europe and stubborn U.S. unemployment should help keep even the 10-year Treasuries at no more than 3% (look out bondholders). Early in the spring, after a brief panic we could all get comfortable with a 5% discount rate for the stock market again.
Let the pending correction run its course, and when you feel like you never want to invest in the stock market again close your eyes, hold your nose and jump right back in.