Fear of Heights
It’s not uncommon for rock climbers to confront some fear of heights at different points in time. This can be due to several factors. On one hand, each of us has their own unique psychological makeup. Some people cannot overcome their own nerves, in certain situations. On the other side, there is the raw exposure, the vastness of the space below. This, in combination with elements such as wind and snow can amplify hollow fear to an insurmountable degree.
Climbers talk of the fear, the tendency to freeze and become unable to decide where or how to move next. These are all sensations stock investors encounter, although and importantly, without the physical risk. The metaphor is effective. Often times, the higher one finds oneself, the more difficult it is to think clearly, to make sound decisions and continue forward. This is where we find ourselves today.
This year, U.S. stocks have scaled heights never seen before. We are in the midst of a fantastic bull market. Stock prices have risen 8 of 10 months this year, a solid 80% and well above the historical 66% average. Bull markets are not precisely defined, but are generally characterized by rising prices, increasing investor confidence and expectations that strong results will continue. Rising markets, such as the one we are in today can remain in place for long periods of time.
Year to date, the S&P 500 has generated a total return of 25.30% – good results for a full year, no less 10 months. For the month of October, stocks rose 4.46%. This is noteworthy as investors are often skeptical of October and this has nothing to do with Halloween. Possibly the most infamous month in market history, October ‘29, ‘87 and ‘08, all saw stock market crashes, drops so precipitous it took years for prices to recover.
One change, something to monitor as stock prices seek new highs, is the rising valuation of the market. According to FactSet Data, the trailing PE ratio (price/earnings ratio) is in the 16x range. PE ratios were in this range when stocks crested back in October ’07. For context, when the market peaked in December 1999 the multiple was over 30x, and when it bottomed in March ’09 it was below 9x. At the current S&P 500 level of $1,766.5, stocks are selling for 16x 2013 expected earnings of $109.7 a share. FactSet aggregate earnings forecast for 2014 are for $120.9 a share or a 10% growth rate. If the PE ratio remains the same (ie. 16x) then the dollar value of the S&P 500 should also be expected to rise with earnings, to a level in the $1,935 range.
As the 3Q2013 earnings season wraps up, I would grade the results a B+. Although the S&P 500 recorded all time high earnings, and the blended earnings growth rate was 2.3% (eight of the ten sectors reported higher earnings relative to a year ago), the results were not glowing. In fact, Wall Street analysts lowered their forecasts for the fourth quarter – aggregate estimates went from $28.90 to $28.46. As noted by FactSet, companies are beating earnings estimates, but fewer are beating revenue estimates. This implies that business levels are not overly strong, even though companies continue to squeeze out higher profits.
For the market to move higher from here, we need growth. Either the PE ratio or corporate earnings must move higher. This is the point where some investors become stuck. They are uncomfortable with the notion earnings can move materially higher. The answer may lie with interest rates. Everyone is afraid of rising interest rates. While there are clear negatives to higher rates, on the positive side, higher rates typically signal stronger levels of economic growth. This will boost corporate earnings and serve as a counter influence to a lower PE ratio.
In my opinion, though there may be some volatility in stock prices toward year end, December and January are seasonally strong months of the year to own stocks. While some may seek to lock in profits, others will be equally keen to own enough stocks and will be bargain hunting. I think the market is one of many leading indicators, signaling the future potential of the economy, GDP, and stock prices.
As we edge closer to the end of 2013, it’s an appropriate time to review your realized capital gains and finalize efforts to offset gains. It has been a good year so you should expect some capital gains. We also want to be sure your accountant knows what to expect. If we have not talked about this, or if there is something else you would like to cover, please feel free to give a call. Just as a reminder, you can review this, and other useful information, on your Tamarac portal.
Bruce Hotaling, CFA