Risks, Rewards, and Valuation
Is the stock market risky?
Photo Rhett Sutphin. Source: Wikipedia
Of course it is. Anyone who went through the Financial Crisis or dot-com crash or Long Term Capital crisis or ’87 crash has experienced the gut-wrenching feeling of having significanlty less in savings than they had just a few months before. Nobody likes that feeling.
And the longer you hold onto stocks, the more likely you are to experience a bear market. These can be caused by wars, recessions, panics, and bad policies coming out of Washington. The world seems like an especially risky place right now, with untested political leadership confronting missile tests in North Korea, terrorist threats around the world, intelligence failures, and a stalled domestic agenda.
So why are market valuations so high?
The expected price-earnings ratio for the S&P 500 – computed by comparing the market’s current market-cap divided by aggregate expected earnings – is 18.5x, above its long-term average. Why – with all the risks that we’re currently facing – is the stock market making new highs?
One reason is earnings. Company earnings are hitting records. Corporate titans like JP Morgan and Johnson & Johnson and Google have never had so much money hit their bottom lines. So S&P 500 earnings are making records, and are expected to grow even more. And all the cash sitting on corporate balance sheets means that these firms have a lot of financial flexibility.
But an even bigger reason is the bond market. With inflation low and stable, bond yields are low and stable, too. Financial assets are ruled by interest rates. It’s one of the first lessons in finance: a financial asset is worth the sum of its future cash flows, discounted to present value by the appropriate interest rate. If interest rates are low, financial assets are worth more.
Does this make stocks especially risky right now?
The short answer is no. Stocks can crash when valuations are rising or when they are falling. They can crash when valuations are high or when they are low. The PE ratio is a poor predictor of market direction, but it’s a decent indicator of long-term returns. High valuations in the early ‘60s were followed by modest returns over the next 20 years; low valuations in the late ‘70s facilitated strong double-digit returns through the ‘90s.
Nothing in life is certain. If we look hard enough or deep enough, though, we can discern some of the broader trends. Equities may be risky, but no riskier than average, it seems. The race isn’t always to the swift, nor the battle to the strong. But that’s probably the way to bet.
Douglas R. Tengdin, CFA