J. Andrew Concannon
Chief Investment Officer
Chief Investment Officer
The U.S. stock market was both a volatile and rewarding place to invest in 2016. Thanks to a sharp year-end rally set off by the U.S. elections, stocks as measured by the S&P 500® Index provided a total return of 11.95% for the year. That satisfactory result should please investors. Yet, what would a stock market rally be if it didn’t raise the usual concerns that stock prices have risen too far too fast or that stocks are overvalued? Hearing those concerns, we decided it was a good time to put some perspective on the recent rally both in absolute terms and relative to past periods during which stocks were clearly overvalued.
When evaluating whether stock prices have risen too far too fast, investors should remember that sharp price rallies and declines, otherwise known as volatility, are part of the stock market’s normal process of price discovery. And to that end, the market’s recent 9% election rally fits well within the range of what is normal. It was in fact the smallest of 2016’s three major price rallies—the other two posting gains of 17% and 10%. All three were preceded by price declines such that much of the gains simply made up for lost ground. Further, the resulting total return for 2016, while attractive, was in no way exceptional. The index has produced higher annual returns in over half of all years since its inception in 1957.
How do the current stock market’s recent price gains compare to past markets that rose too far too fast? To answer that question, we turn to Table 1. Stock prices peaked in both 1987 and 2000 after exceptional multi-year rallies pushed prices up in excess of 20% annually. During both periods, high optimism drew new investors to the market. The current market differs greatly with prices rising at more modest rates. Recent price gains, especially over the past three years, could be better described as ordinary.
But what about the stock market’s valuation? Are stock prices too high relative to underlying earnings?
In Table 2 we turn again to the market peaks of 1987 and 2000, two periods that can safely be described as expensive. As the table shows, the market’s valuation as measured by its P/E ratio (price divided by past 12-months earnings) is lower today than at either of the two market peaks shown. However, we note that the current P/E ratio is not low relative to its long-term average of just above 15.
Investors should not view stock valuations in isolation. When comparing P/E ratios from different points in time, for example, it is also necessary to compare interest rate levels. Interest rates rose sharply going into both the 1987 and 2000 peaks, raising the yield on the 10-year U.S. Treasury bond above its 60-year average of 6%. By comparison, interest rates are currently at historically low levels.
To compare the stock market’s valuation with interest rates we calculate the earnings yield (earnings divided by price). As shown, the current earnings yield for the S&P 500® Index is well above the yield on the 10-year U.S. Treasury bond, meaning that stock investors receive more earnings for each dollar invested than bond investors receive in interest. The opposite was true during 1987 and 2000, reflecting the much higher relative valuations of stocks versus bonds at those times. This indicates that current stock valuations are far more reasonable relative to interest rates than at those market peaks.
Putting this together, we see a stock market that has produced solid price gains, but not gains that are out of the ordinary. And we see a market valuation that is above average but within a reasonable range relative to current interest rates. This leads us to believe that stock prices have room to move higher if corporate earnings grow as many analysts currently project.
It is, of course, impossible to accurately predict short-term stock market moves on a consistent basis. Fortunately, long-term stock investors do not need accurate short-term predictions to benefit from investing in the stock market. Turning to the long-term, below are our 10-year outlooks for both stocks and bonds.
Our 10-year return outlook for U.S. stocks is reduced slightly from last year. Our change in outlook results from stock prices rising more in the past year than our trend earnings estimate. Our model forecasts an annualized total return range for the S&P 500® Index of 5.1% to 7.3%. This range remains below the market’s long-term annual return of approximately 10% due to an above-average valuation and below-average dividend yield. One positive qualification to our return estimate is corporate taxes. Should Congress choose to lower corporate tax rates, our trend earnings estimates will increase, thereby raising our forecast for expected returns. The change in earnings could be significant. According to Thomson Reuters, every one-percentage-point drop in overall federal corporate tax rates increases the S&P 500 Index’s 2017 earnings estimate by one percent.
Our 10-year outlook for bond total returns is based on the assumptions that interest rates will gradually rise and that spreads (the difference in yield between bonds with credit risk and U.S. Treasuries) will widen. Most helpful to long-term returns will be an increase in interest rates because the interest paid by investment grade bonds is currently well below long-term averages. However, a rise in rates will cause bond prices to fall which will subtract from total returns. Our model, taking all of this into account, forecasts that annualized returns over the next 10 years will average just below 3% for portfolios of U.S. Treasury and corporate bonds with 1 to 10 year maturities. We expect our future forecasts will rise along with any increases in interest rates.
The information provided in this material should not be considered as a recommendation to buy, sell or hold any particular security. This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be correct. Actual results may differ materially from those we anticipate. The views and strategies described in the piece may not be suitable to all readers and are subject to change without notice. You should not place undue reliance on forward-looking statements, which are current as of the date of this report. The information is not intended to provide and should not be relied on for accounting, legal, and tax advice or investment recommendations. Investing in stocks involves risk, including loss of principal. Past performance is not a guarantee of future results.