By David Deacon
Investors should continue to exercise caution.
By many measures, stock valuations are at levels which have always preceded significant market corrections. The overall value of the S&P 500 in the U.S. (market capitalization) is 1.25 times the value of the Gross Domestic Product (GDP) of the U.S. This is the second highest reading in history, with 1.45 in the year 2000 being the highest, and is twice the long term average.
In other words, stock valuations have roared ahead of economic growth. Will the economy catch up and justify current prices or will it continue along its anemic growth path, with stocks falling back to historic valuation levels?
The Federal Reserve is doing all they can to promote the former. Their Quantitative Easing (QE) program of money printing and bond buying is intended to hold interest rates down and, consequently, force conservative investors into the stock market in search of higher yields, pushing stock prices higher. It is believed that investors with higher portfolio values will feel wealthier and will spend more money, thus, boosting GDP. After four years of QE, stock prices have certainly climbed, as planned, but economic growth has remained slow.
Corporate leaders are not convinced that this growth model is sustainable and have been reluctant to spend money on new capital projects and labour. Janet Yellen, the new chairperson of the Federal Reserve, mentioned deflation for the first time in a speech last week. (See my November 26, 2013 column in this paper titled “Should the Real Concern Be Deflation?”). Meanwhile, the stock market has climbed to overvalued levels on record high margin debt.
Reduce risk and rebalance portfolios into bonds. There have been 24 years since 1929 when stocks produced negative returns. In all but three of those years, bonds produced nice gains, while providing a very high degree of safety. Some examples are below:
1932 (stocks dropped 8.6 per cent, bonds gained 8.8 per cent)
1957 (stocks dropped 10.5 per cent, bonds gained 6.8 per cent)
1981 (stocks dropped 4.7 per cent, bonds gained 8.2 per cent)
2000 (stocks dropped 9.0 per cent, bonds gained 16.7 per cent)
2002 (stocks dropped 21.9 per cent, bonds gained 15.1 per cent)
2008 (stocks dropped 36.5 per cent, bonds gained 20.1 per cent)
Bonds have outperformed stocks so far in 2014.
If the bulls are correct, the upside potential for stocks this year is five to 10 per cent. If the bears are correct, the downside risk is 30 to 50 per cent. From a risk/reward perspective, it may make sense to lean toward safety. To obtain a copy of supporting research material on this, or related, topics, please send an email to firstname.lastname@example.org.
David Deacon is a portfolio manager with Raymond James Ltd. The views of the author do not necessarily reflect those of Raymond James. This article is for information only.