With the US stock market seeing gains in each of the last 4 calendar years and rising 12% so far in 2013, many investors are worried that the stock markets are overvalued.
If we look at the fundamentals and indicators, we could come to the opposite conclusion reasoning that it is the bond market that has the greater risk of a major selloff.
The Federal Reserve has been consistent in its stance that they will keep interest rates low to support the economy as unemployment is still hovering around 8%. The lack of yield available on fixed income has investors turning toward dividend paying stocks to supplement income as the yield on the S&P 500 is more than the sub 2% yield on the 10 year Treasury bond. With inflation being tame, there is reason to believe that Treasury bond yields may remain close to those levels for the time being.
Analyzing the stock market fundamentals, we can surmise that even with the multi-year gains, the equity markets are still not overvalued from a historical perspective. Currently, the S&P 500 is trading right at its’ historical price to earnings ratio (PE) of around 14. Typically, markets tend to peak when the S&P 500 is trading at a PE of around 18 or 19. Thus we can make the case that based on valuations; we may still have some upward movement before the market cycle peaks.
A common indicator of a peaking market cycle is yield expansion. When the economy is growing, inflation begins to rise and the Federal Reserve will begin to raise interest rates in order to keep inflation contained. The average yield on the 10 year Treasury bond is around 4%. Right now, the 10 year Treasury is around 2%. If we use the 4% yield as our basis for a normal environment, the Federal Reserve will need to raise rates by 2% to get there. If we conclude that rates would have to be north of 4% to signify yield expansion, and that the Federal Reserve will increase the rates at a systematic pace as to not completely collapse the bond market (a 1% rise in rates would cause a 10% reduction in bond principle), we should have quite a while before yields get to a place where they will temper the equity markets.
Although a 5% to 10% correction in the equity markets is something that would not come as a surprise, any pullback that is not caused by a significant political or economic event should be short lived. Such an event would provide an entry point to, what we believe are, positive long term prospects for the equity markets.
As always, I stress that in this ever-changing political and economic environment, sensible diversification is the key to weathering any market uncertainties.
Jason M. Vavra, CPA, PFS
The information contained herein is not considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecasted in this report will be realized or achieved. Past performance is no guarantee of future results.