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The following article was shared exclusively with our wealth management clients on April 1st of this year. Given the massive swings that the U.S. equity market is experiencing, we want to share this with the rest of our tax and financial planning clients. These massive swings may be a warning, so here are few thoughts to consider. We hope you find it helpful.
The recent massive swings in the U.S. equity market are typical of a market top and may be a warning for all of us. While no one can predict the future direction of the stock market, the bond market or the economy, we can look at past market data and use it to inform our decisions.
One of the data points we look at when analyzing the market is the CAPE ratio. The CAPE ratio is a method of measuring the price of the stock market relative to earnings. More specifically, it measures the average adjusted earnings over the past 10 years and then adjust it for inflation.
While there are hundreds of ways to view the market, we view the CAPE ratio as an overly simplified way to look at the ”expensiveness” of the market relative to historical valuations.
When the CAPE ratio is extremely high, it tells us that we are paying a lot more for a dollar’s worth of earnings than we’ve paid in the past. When the CAPE ratio is extremely low, it tells us that we are paying a lot less than what we’ve paid in the past for that same dollar’s worth of earnings.
When the CAPE ratio is high, this is an indication that the market could be expensive and may have room to fall. When the CAPE ratio is low, this indicates that the market could be cheap and may have potential to appreciate.
SOURCE: multpl.com
In looking at today’s CAPE ratio, stocks look pretty expensive. The 10-year CAPE ratio is 37.3. Considering that the long-term average for the CAPE ratio is around 17, it would take a decline of more than 50% (at today’s earnings) to get back to the long-term CAPE average. This simple metric doesn’t guarantee that the market is going to fall by 50%. It simply tells us that there is a lot of room for the market to drop before it comes back in line with historical valuations, as measured by the CAPE ratio.
The bottom line is that stocks are more vulnerable when valuations are this high.
And if you’ve read any of our recent posts, you would know that the probability of a recession greatly increases when the Fed begins raising interest rates.
Additional data points to consider:
The yield curve (looking at 2-year vs the 10-year treasury yields) is nearly inverted. This is another indicator that recession risks could be increasing.
The Fed is switching from quantitative easing (QE) and buying $140 billion in securities a month to liquidating its balance sheet. That is a significant shift in policy.
The Fed can impact monetary policy, but it has less impact on the supply or demand for goods and services. While the shipping backlog is improving, consumers account for 70% of U.S. GDP. And hourly wages are not growing fast enough to keep up with inflation. Combining the real wage decline with the 1.5 million people who have chosen early retirement could lead to reduced consumer spending in the future.
Reduced consumer spending also increases the risk of a recession.
SOURCE: nerdwallet.com
And one last data point to consider: If mortgage rates continue to increase from here, then the housing market could also face some major headwinds, and consumers will have less cash to spend if their monthly mortgage payment rises significantly from higher interest rates.
And this brings us back to our first statement. With the increasing risks of a recession, it’s a good time to revisit your mix of stocks, bonds and cash. Many experts would argue that cash is a horrible place to sit when inflation is north of 6%, and we would agree. But cash is not a bad place to sit if you believe there is a growing risk of recession. If a recession is the next stop on our bus tour, then cash, high-quality bonds and defensive stocks are worth considering.
This article is a general communication being provided for informational and educational purposes only and is not meant to be taken as tax advice, investment advice or a recommendation for any specific investment product or strategy. The information contained herein does not take your financial situation, investment objective or risk tolerance into consideration. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. Any examples are hypothetical and for illustration purposes only. All investments involve risk and can lose value, the market value and income from investments may fluctuate in amounts greater than the market. All information discussed herein is current only as of the date of publication and is subject to change at any time without notice. Forecasts may not be realized due to a multitude of factors, including but not limited to, changes in economic conditions, corporate profitability, geopolitical conditions, inflation or US tax policy. This material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.
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