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Watch the Numbers, Not the Russians

By Jim Pearce on January 13, 2017

The release of an unverified document purporting to contain embarrassing and unethical behavior by President-elect Trump while doing business in Russia has understandably dominated the mainstream news outlets this week. Even if it all turns out to be “fake news” as Trump insists (and let’s hope that it does), the nature of the allegations are too tempting for the media to ignore in favor of “boring” financial news.

But starting today, a torrent of quarterly and year-end earnings reports will be released over the next several weeks that should matter more to investors since they will shape the stock market’s behavior for months to come. In addition to revealing the final accounting for revenue and earnings in 2016, more significant will be the guidance as to what is expected in 2017.

For that reason, the next three weeks could be a particularly volatile period for the stock market. Combined with the transfer of power from Obama to Trump, investors will be parsing every word in these statements for hidden meaning. And given how much uncertainty there is regarding Trump’s true intentions regarding foreign policy, tax reform and a number of other legislative items, I suspect many companies will err on the side of conservatism.

Although it is generally good management practice to under promise and over deliver, too much of it could trigger a stock market correction at this delicate time. Every major U.S. stock market index has recently achieved record highs despite a decline in total earnings for the S&P 500 over the past three years. The index generated total EPS (earnings per share) of $105 in 2014, but dipped all the way down to $88 for 2015.

Through the middle of 2016 that figure came in at $87 for the trailing twelve months, so unless the last six months of the year went gangbusters then it is likely 2016 will also fall well short of the 2014 high-water mark. From a purely mathematical perspective, that can only mean one thing: the stock market has grown in value over the past two years due to an escalating earnings multiple, which is now near historically high levels.

At the start of 2014 the trailing P/E (price to earnings) ratio for the S&P 500 was a little over 18, pretty close to its historical average. At the onset of 2015 it jumped to 20 times earnings, and last year it leapt again to 22.  Although the final numbers for 2017 aren’t in yet, a multiple of around 26 times earnings is the unofficial estimate by most analysts.

That’s a big problem, because history strongly suggests that a P/E multiple that far above its historical average is not sustainable. At the start of 1998 the P/E multiple for the index was 24, about what it averaged for all of 2016. The stock market continued higher for two more years, but then came crashing down. At the start of 2008 the multiple was 21.5, about 10% less than current levels yet we all know what happened in the fifteen months that followed.

Most stock market corrections occur when logic catches up with emotion. In short, the current valuation of the stock market is either too high, or corporate earnings are going to explode to the upside this year to bring the P/E multiple back into line. The post-election rally has been fueled by emotion, so now the facts, in the form of the hundreds of corporate earnings reports about to be released, will either confirm or refute the current level of optimism.

If, like me, you are concerned that even a modicum of bad news could send the stock market reeling there are several steps you can take to mitigate that risk. For example, in recognition of the elevated level of risk in the stock market, recently I adjusted my asset allocation model by reducing the portion allocated to stocks while putting more money into cash and commodities.

I have also recently sold some stocks out of my Personal Finance Growth Portfolio that were trading at P/E ratios far above the market’s already high earnings multiple. If a correction occurs, momentum stocks like these will most likely bear the brunt of the damage. I have also raised the stop-loss levels on other holdings that appear fully valued or are beginning to exhibit signs of technical weakness.

All of that should help mitigate the damage from a correction, but will not eliminate it altogether. Obviously none of us ever want to lose money, but there can be substantial tax liabilities to liquidating your portfolio entirely. For that reason the prudent approach is to review your asset allocation and portfolio holdings to determine what, if any, steps should be taken now to reduce losses while valuations are still high.

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