The S&P 500 notched an all-time record high of 2130 on May 21, 2015. That was 10 months ago. Since that date, the popular gauge has suffered two faith-rattling corrections – a 12% decline in August of 2015 and a 14% pullback in February of 2016. Granted, U.S. stocks rallied back to respectable levels after each sell-off. On the other hand, the index has yet to make any bull market progress for the better part of a year.
Regrettably, news providers have been noticeably bearish near the market’s valleys; they’ve been decidedly bullish whenever the S&P 500 has pulled within spitting distance of May’s high-water mark. Wouldn’t it be refreshing if financial media mega-stars expressed enthusiasm when stocks sink to 52-week lows? When investors stand a better chance of buying lower?
Instead, CNBC mouthpieces typically articulate confidence at overvalued levels. For example, Factset recently documented that the current GAAP P/E ratio of 23 sits in the 99.5 percentile of trailing twelve month (TTM) stock valuations. In other words, stocks may be more exorbitantly priced right now than at nearly any other point in market history.
It gets worse. Stocks are exceptionally “overbought” on technical indicators like relative strength (RSI). One considers stocks to be overbought when RSI rises above 70. Today? The S&P 500’s RSI (7-day) is above 80 for the first time since the infamous “Bullard Bounce” from November of 2014.
Perhaps ironically, the S&P 500 is more expensive at 2050 today than when the benchmark notched 2075 in November of 2014. Back then, the GAAP P/E of 21 may have been semi-ridiculous. Yet investors at least had an expectation of 7%-10% earnings growth going forward. Since that time, earnings have declined for three consecutive quarters (Q2, Q3 and Q4 of 2015) and they are widely anticipated to fall more than 8% for the first and second quarters of 2016. Translation? Forward P/E ratios portray stocks as incredibly overvalued every bit as much as current P/E ratios.
Naturally, there are those who foolishly recite the mantra of “low interest rates make stocks the only game in town.” Those folks have little understanding of the history of low interest rate periods (i.e., 1936-1955), let alone recent history. Low borrowing costs did not stop bear markets occurring in 1937-1938 (-49.1%), 1938-1939 (-23.3%), 1939-1942 (-40.4%), or 1946-1947 (-23.2%). Keep in mind, the stock bears in 1939-1942 (-40.4%) and in 1946-1947 (-23.2%) occurred well after the Great Depression; investors had low interest rates, a booming economic backdrop and attractive stock valuations.
What about recent history like the last 10 months? We can look at the performance of stocks, bonds and cash proxies since the S&P 500’s peak last May. We can even break down the performance by equity type (e.g., small, large, cyclical, non-cyclical, etc.), investment grade bond type, (e.g., long maturity, intermediate maturity, tax-exempt, corporate, treasury, etc.) as well as cash alternatives (e.g., T-bills, U.S. dollar, gold, etc).
Several things stand out in the chart above. First, if investor risk preferences have not changed since May of 2015, wouldn’t the riskiest segments in the stock universe be outperforming? Economically sensitive cyclical sectors like industrials and financials should out-hustle non-cyclical “recession-proof” segments like utilities and consumer staples. Instead, the opposite is true. Smaller companies would typically lead larger ones; instead, the perceived safety of larger companies has been winning the battle.
Second, if investor risk preferences have not shifted from “risk-on” to “risk-off,” then why are investment grade bonds, currencies and precious metals outperforming stocks? And it’s not just the yellow metal or an aggregate bond index that is succeeding. The longest end of the yield curve, the longest maturity corporate bonds and the longest maturity municipal bonds are carrying the torch.
It follows that safety-seeking has been in vogue for quite some time; that is, if stocks were the only game in town, there would not be clear-cut demand for U.S. treasuries via iShares Barclays 20+ Year Treasury (TLT), long-term investment grade corporates via Vanguard Long-Term Corporate Bond (VCLT), municipal bonds via SPDR Nuveen Barclay Municpal Bond (TFI), precious metals via SPDR Gold Trust (GLD) or cash equivalents via iShares Short-Term Treasury (SHV).
Indeed, the fact that a diversity of bond types have been outperforming stocks – the reality that gold and cash alternatives are also outperforming U.S. equities – tells us that stocks are not the only game in the investing township. It also tells us that additional asset classes provide enhanced risk-adjusted returns for a well-diversified portfolio.
Bear in mind that 93% of stock market gains since March of 2009 are directly attributable to the expansion of the Federal Reserve’s balance sheet (a.k.a. quantitative easing or “QE”). While one of the goals of QE activity is to manipulate interest rates lower to make stocks more desirable, QE also impacts the money supply, investor psychology and currency exchange rates. QE since 2009, not “low interest rates,” has been the elixir to make stocks soar.
Here’s another truth: There have not been any stock market gains for Vanguard Total Stock Market (VTI) since the last QE asset purchase on December 18, 2014. Absent a fourth iteration of quantitative easing (“QE4″) – absent the stimulant that provided 93% of the price appreciation for the S&P 500 to this point – investors would be wise to maintain a healthy allocation to non-stock assets. In fact, zero percent yielding cash may be the best asset of them all; zero-percent yielding cash is what one needs to buy stocks at lower prices.