Dow 17000 has been achieved and the S&P500 is near 2000! These levels and the stellar performance of the market since the lows in 2009 raise the obvious questions; how far can the market rise before this bull market runs its course or corrects significantly. Every day we read or hear someone’s prediction or get questions from our clients’ about when the market will suffer a pull back. It may be interesting to note that the market has corrected 5% or more an average of six times a year since 1980. It is reasonable to expect a correction. We believe some backing and filling will actually be healthy for the market intermediate and longer term. In fact, there have been four declines of around 5% in the last 12 months (see chart) and yet we are still near all-time highs.
Just as the chart indicates, a correction will come, however, we think this bull is intact and there will be buyers on that pullback. Another common concern is that we are at “all-time highs”. Remember that the indices are price weighted. In other words, it is only the price per share of the underlying index components that create the level of the index itself. The index does not have anything to do with earnings and how they are valued. We would argue that from a valuation standpoint, we are nowhere near the all-time high. An interesting statistic is that 71% of the time, a new index high is followed by a positive three year return. The average three year return following a high for the index has been 22%.
We believe the overall market fundamentals remain positive. Though stocks are not as cheap as they were, they are currently valued at about the average historical valuation and are not yet expensive. Interest rates remain positive for equities as well. The cost of capital to run, start or grow a business is low. Also, bonds are the wrong way to mitigate risk. The interest rate risk of the bond market may create even more liquidity for the market in time when interest rates begin to rise. There is currently little competition for equities.
Corrections and backing and filling are normal in the context of a bull market. We contend that any pullback will still be relatively short lived and shallow. Until there is a change in the underlying fundamentals, we continue to expect any dips to be an opportunity rather than a reason for broader concern. The market is a long way from the euphoric overvalued phase when bull markets finally fail.
We will remain vigilant and will be proactive when necessary but for now, we are positive about the intermediate and longer term prospects for the market. Corporate earnings are still growing and the potential for acceleration of economic output remains quite possible the balance of the year.
Stay cool and enjoy your summer.
Royal Fund Management, LLC