Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
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EQ: The market has been a bit topsy-turvy in December, and has been sagging this week on positive news for the economy—potentially influencing the Fed to act sooner. What do you make of the market’s recent behavior?
Stovall: It’s consistent with investors who believe that the Fed will begin its tapering program in December, and announce it at the upcoming meeting. Or, if they don’t enact it this month, they may at least announce it this month and begin tapering in early 2014. The economic data have been coming in stronger than expected. Also, Congress has actually been playing nice, coming to what appears to be a budget compromise. So it no longer seems that the Fed needs to be the backstop for Congress, which has been dysfunctional throughout most of 2013.
EQ: Is this a bit of a surprise because it seemed like most investors and traders were looking at a longer-term timeline around March?
Stovall: It was a bit of an awakening. I like to say that the equity markets may now have to contend with starting a stimulus diet before the holidays get into full swing, rather than just placing it high on a list of New Year’s resolutions. I think the market was expecting that they would have to start worrying about tapering to begin in the first quarter, possibly as late as March, but now most people will believe the Fed will begin tapering or at least announce the beginning of tapering in December.
EQ: In this week’s Sector Watch report, you discussed the similarities between the price charts of the 2012-13 market and that of the 1928-29 run. Why is that a concern for some investors and traders?
Stovall: The chart that has been floating around shows a very similar path that the two markets have been taking. Obviously, we know how the 1928-29 bull market concluded, and investors are worried that the current bull market will have its own Thelma & Louise moment driving off a cliff.
I noticed, however, that the scales of the two markets were different on that chart that has been floating around. If you actually apply the same magnitude as if you’re putting it onto a log scale where it shows percentage change rather than the absolute price change, they are actually very different. The angle of ascent for the current bull market is about half that of the 1928-29 bull market. So maybe it’s not as much of a lockstep ascent that we have to worry about as we initially thought when we looked at the inappropriately scaled chart.
EQ: Could we still experience the same kind of price direction on a lesser scale, or does factoring in the magnitude make the comparison irrelevant?
Stovall: We could easily fall into a pullback or maybe even a correction. We are now 26 months away from the last decline of 10 percent or more, and on average, there’s only an 18-month separation. So we’re due, but we just don’t know when it’s going to happen. I don’t believe corrections have been repealed, though they’ve frequently been delayed.
So I think that we could end up seeing a decline of anywhere from 10 to 20 percent, but I do not expect to see a decline beyond 20 percent, and certainly not something close to the 89-percent that we ended up seeing after the peak in October 1929.
EQ: We’ve discussed the Rule of 20 before, which is if the sum of the trailing 12-month price-to-earnings ratio and the inflation rate is below 20, it indicates the market is still fairly or undervalued. Where are we right now in regards to that level?
Stovall: Well, here we are almost midway through December, and if you look at the P/E based on the September quarter earnings, fair value would be placed around 1803 on the S&P 500. So using the P/E, which is a shade above 19, on the trailing four quarter GAAP earnings, combine that with the rate of inflation, which is 0.9 percent—it means that we’re about fair value as of about a week ago.
If you include the fourth quarter earnings—since we’re almost at the very end of this earnings period–then fair value actually appears to be closer to the 1860 level on the S&P 500. If you take it out to the end of 2014, looking at GAAP earnings of $108, combined with headline CPI forecast of 1.6 percent, that means that fair value on the S&P 500 could be close to 1990. So that’s a good 10 or 11 percent above where we are right now.
Of course, there’s no guarantee that the Rule of 20 will work this time around, as we know history is a great guide but never gospel.