Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: The S&P 500 on Tuesday and Wednesday walked right up to the all-time high and again was unable to open that rusty door. Has this been more stubborn than you anticipated?
Stovall: Not necessarily, because it is a very important threshold. It’s an all-time high that was just slightly above the prior all-time high from March 24, 2000. Subsequent to each bull market reaching close to those levels, we suffered through a mega meltdown, which is a bear market of 40 percent or more. So I think that there were an awful lot of investors who had purchased at around the high on October 9, 2007, and are now just getting back to break-even. Therefore, they’re probably thinking to themselves that maybe they’ll take some money off the table, wait for a pullback in prices, and then put money back to work in the hopes of making at least a little bit of profit since they have been out of the game for so long.
EQ: In this week’s Sector Watch, you tackled the question of whether stocks could increase P/E multiples in a slow economic environment. While it is possible for that to happen, you did find that historic samples did vary greatly. Can you tell us more about that?
Stovall: Basically, this question stemmed from my traveling to speak with clients and to present to individual investors when I was frequently asked how the S&P 500 earnings could increase and how the P/E multiples could expand even though we’re going through below-average growth in U.S. GDP. My response was, first off, investors are anticipators and they look to make decisions based on where they think the economy is going to be six to 12 months from now. Also, what I find is a lot of investors say it’s not just the U.S. anymore. The global economy is growing at a more rapid pace than the U.S. is individually, and in particular, the emerging markets are growing at a rate of more than 5 percent. Basically, the fishing in general is better overseas, particularly in the emerging markets.
So if you looked to history to see if we could apply a year-over-year percent change in GDP, and where the P/E of the S&P 500 was, could it imply that a rising multiple is possible even if we do have a relatively weak GDP growth rate? By looking at both measures of analysis—meaning the GDP and also looking at Leading Economic Indicators, which is more of a forward looking predictor—I found that the U.S. market appeared fairly valued today. At the same time, I found that prior ranges were fairly high, looking at P/Es from as high as 46 times to as low as to about 7 times. So the wide range of results made me feel a little less confident that GDP or the Leading Economic Indicators were a very good predictor of where the market would be headed.
EQ: What would be more effective indicators to look at in your opinion?
Stovall: I’ve frequently been asked that if I could have one indicator, which would I choose? I think it would have to be the yield curve. If I could ask for a second thing along those lines, it would be the trend in the yield curve. Basically, it tells me how much investors have to pay for future earnings. What is the discounting factor? I would tend to say interest rates are probably the most important element in knowing where the economy is headed, because typically an inverted yield curve—meaning short-term rates are higher than long-term rates—has signaled that a market top is near because a recession is approaching. On the other hand, a fairly wide and upwardly sloping yield curve implies the economy is growing and inflation could be a possibility down the road. So purchases of longer-dated bonds need to be paid that extra yield to overcome that uncertainty down the road. Therefore, I would definitely say that interest rates are the one factor I would pay more attention to rather than GDP or leading economic indicators.
EQ: The uneasiness of investors toward Europe’s financial situation is intensifying once again. Should the market buckle up its safety belt?
Stovall: Yes, I believe we should. As I mentioned in our previous interviews, once the market gets back to break-even, we tend to see an additional 3 percent tacked onto the eclipsing of the all-time high over a two-month period, but then we slip into a decline of 13 percent on average. However, it has usually ended up being a better buying opportunity than a reason to flee equities. Of course, there’s no guarantee that it’s going to be the case this time around, but I believe that at least the volatility will be increasing. So fasten your safety belts, but at the same time, look at price declines as more of an opportunity to add to positions, especially if you have been underexposed to equities for quite some time.
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