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Your Alternative to a Stock Market Correction

By Jim Pearce on January 26, 2018

While on vacation last week, I pondered the past year and what we can learn from it as 2018 gets underway. My concern for a stock market correction in 2017 did not materialize. In fact, the S&P 500 Index gained nearly 22% last year, about twice its long-term average rate of growth.

That’s great news for investors, but the trade-off is that by almost any measure large-cap stocks are expensive. The S&P 500 Index is currently priced at more than 18 times next year’s estimated earnings. That’s about 20% above its historical average.

The stock market’s earnings yield (the inverse of its current P/E ratio) of 4.4% is nearly 200 basis points (2 percentage points) above the 2.6% yield on the 10-year Treasury note. That is also unusual from a long-term perspective.

 

Normally, when the stock market is trading at high earnings multiples its earnings yield is less than what you can get from bonds. However, since 2009 the earnings yield for the stock market has been higher than the bond yield. In large part that is due to the Fed pushing interest rates down to help the economy get back on firm footing.

Now that the economy on is firing on all cylinders, we would expect the bond yield to gradually rise above the stock market’s earnings yield. There are three ways that can mathematically happen:

  1. Bond yields double while stock market remains unchanged;
  2. Earnings yield drop in half while bond prices remain unchanged;
  3. Bond yields rise while the earnings yield drops.

Needless to say, none of those choices are appealing to most investors. If Treasury bond yields double, that probably means inflation is growing much faster than expected. It also means borrowing costs for the federal government will be higher than forecast, adding to the deficit.

If the earnings yield for the stock market drops in half, that could mean earnings remained the same but stock prices dropped in half, similar to what happened ten years ago. Or, stock prices could remain constant while earnings double. However, it is difficult to imagine a scenario where something like that could happen.

A less severe and more likely outcome is #3, involving some combination of the two. The yield on the 10-year Treasury note could gradually rise above 3% as inflation starts to pick up steam, while the stock market goes through a 20% correction at the same time.

If that were to happen, the stock market’s forward P/E ratio would revert to its historical norm, while the 10-year Treasury note would still be yielding considerably less than its long-term average.

In short, what I am describing is nothing more than a simple reversion to the mean. It would not represent a meltdown of the global financial system, nor would it qualify as a full-blown crisis compared to what happened ten years ago.

Alternative Universe

Stock market pundits frequently use the acronym TINA (“There Is No Alternative”) to explain the 35% rise in the stock market over the past two years. In the wake of The Great Recession, U.S. large-cap stocks were viewed as the least risky bets while Europe and Asia struggled to regain financial traction.

The logic behind that argument makes less sense now that the rest of the developed world has firmed up their economies. There are many viable alternatives to U.S. stocks, as evidenced by these recent trends:

  • The iShares Europe ETF (IEV) posted a 24.8% total return for 2017 while the SPDR S&P China ETF (GXC) gained 51%, more than double the return of the S&P 500 Index;
  • Over the past six months, both the Vanguard Energy ETF (VDE) and the Fidelity Global Commodity Stock Fund (FFGCX) gained 21%;
  • During the four weeks following the December meeting of the Fed, the SPDR Gold Shares ETF (GLD) gained 6.3%.

The meteoric rise of bitcoin in 2017 is also worth noting. Whether it was a harbinger of future disruption of the global currency markets or merely a fad, it created an entirely new asset class that is here to stay.

The bad news is there probably isn’t as much upside potential in U.S. large-cap stocks in the near term. The good news is there are many other places you can put your money to continue earning outsized returns, such as THESE.


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