Monday, January 20, 2020

Investing In An Elevated Market

Two years ago to the day on January 20, 2018 I wrote a post, Will The Stock Market Ever Decline Again?, and it seems in January 2020, investors are faced with the same question. Written commentary today is mirroring commentary of two years ago as January's market has gotten off to a strong start just like in 2018. Historically, strong starts to a January are a positive predictor for market returns in the balance of the year. That was not the case in 2018 as that year was a down year for the S&P 500 Index.

Investors are now faced with a market that is generating another streak consisting of positive quarterly returns as seen in the below chart. The green bars indicate the Index generated a positive return in the respective quarter. Noted on the chart are two sets of quarterly returns where the market rose for nine consecutive quarters. The nine quarter streak was broken in the second set after I wrote that earlier referenced article in 2018. The market is now working on another streak with five positive quarterly returns since the beginning of Q1 2019 although this quarter is yet to be completed.

Investors who deployed cash into stocks in January 2018 were quickly met with a pullback in stocks culminating in a negative first quarter 2018 that ended the second nine quarter positive return streak. The recovery from the March low was steady until the fourth quarter of 2018 which saw the market decline nearly 20%. Importantly though, the return for the S&P 500 Index over this two year stretch is 19%. As is often said, patience is a virtue.

Since the beginning of December 2019, the market has accelerated even more quickly to the upside. This move higher is occurring in an environment with a low level of volatility. As the below chart shows, the S&P 500 Index last had an up or down move in excess of 1% in mid October last year. And concurrent with the market's move higher is the fact most of the moves have been positive ones; hence, more green than red bars on the chart.

Admittedly, there are some valuation measures that would suggest stocks are not inexpensive and the bears are pounding the table with these. However, some measures suggest the market is not overly extended. One such measure, the Earnings Yield Spread (EY Spread), shows stocks are significantly undervalued (h/t: Jeff Miller-Dash of Insight.) The EY Spread is the forward earnings yield for the S&P 500 Index minus the Moody's Baa corporate bond yield. A Baa corporate bond is Moody's lowest grade for an investment grade corporate bond. Even the P/E for the S&P 500 Index may not be overly extended when evaluated in context with market interest rates, i.e., at lower interest rates stocks tend to trade at higher valuations (Rule of 20.)

I have noted in a few prior posts that investors hold a high level of cash that continues to increase and now equals $3.6 trillion. Investors continue to shun equities based on mutual fund and ETF flow data. Specific detail can be reviewed at the Investment Company Institute's website (

So what is an investor to do? The most important thing for investors is to have a plan, i.e., an investment plan along with a financial plan. Evaluate one's investment goals and confirm the current investment allocation remains in line with one's original plan. Maybe the asset allocation needs to be adjusted, but make adjustments in the context of one's overall goals and objectives and not simply based on emotion.

Morgan Housel wrote another excellent article, Risk is What You Don't See, and so often we tell our clients it is the unknowns that most often alters the market's direction. Morgan Housel states in his article,
"Paying attention to known risks is smart. But we should acknowledge that what [we] can’t see, aren’t talking about, and aren’t prepared for will likely be more consequential than all the known risks combined."
The U.S. market, specifically the S&P 500 Index is on a nice run since the end of the financial crisis as seen below. Notable though is the fact the S&P 500 did not sustainably surpass the technology bubble peak of 2000 until 2013, the start of the current bull market. In other words, the equity market covered 13 years before an investor in 2000 was back in positive territory again. The current bull market is approaching seven years in age then. If history is a guide, further market upside would be expected in this secular bull market, but the market will not move higher in a straight line.

At this point in time much market commentary is highlighting data points suggestive of an over bought market, i.e., low put/call ratio, elevated relative strength figures, some elevated sentiment indicators, and as noted earlier, some elevated valuation measures, just to name a few. A pullback would not be a surprise; however, if corporate earnings in the coming year are near expectations, this likely is a positive for the market in the year ahead.

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