The stock market has few believing that it’s trading anywhere near a bargain price, yet nearly all are expecting the major averages to be higher next year — a recipe for trouble if earnings or economic data disappoint, according to analysts at Bespoke Investment Group.
Bespoke analysts recently introduced their “Irrational Exuberance” Indicator, which uses monthly Yale School of Management sentiment data compiled by Nobel laureate Robert Shiller. He authored the best-selling book, “Irrational Exuberance,” and the phrase harkens back to 1996 remarks about the frothy stock market uttered by then Federal Reserve Chairman Alan Greenspan.
The indicator combines two sentiment readings: one that asks investors how confident they are that the equity market will be higher a year from now and another that tracks how confident investors are in the valuation of the market.
The percentage of both retail and institutional investors who think that the market is cheap is at the lowest level since 2000, which is not surprising given that stocks are trading at the highest multiples since the days of the tech bubble.
Valuation metrics are pretty useless as predictors of market tops or bottoms, but they do have a good record of forecasting long-term average returns. For example, the cyclically adjusted price-to-earnings ratio, or CAPE, devised by Shiller, is at 29, the highest since 2000. When CAPE is at these levels, 10-year average returns are forecast to be in the low-single digits.
Despite investor agreement that stocks are expensive, however, the vast majority of retail and institutional investors believe the market will continue to rise for another year.
The difference between one-year price confidence and valuation confidence makes up the “Irrational Exuberance” indicator.
“When the resulting reading is high, it means investors expect the market to go up, but they don’t like the market’s valuation. When the reading is negative, it means investors find the market’s valuation attractive but they don’t think the market is going to go up,” said George Pearkes, macro strategist at Bespoke Investment Group.
“People expect the market to go up because they expect earnings to rise, but if underlying fundamentals disappoint, the pain will be greater than if we simply expected no growth or negative growth. It is difficult to say how much the market will drop as we don’t have any precedent for such sentiment,” said Pearkes.
It is understandable why investors would pay such high prices. According to FactSet, analysts are projecting earnings growth of 10% and revenue growth of 5.4% for the S&P 500
During the first quarter of 2017, S&P 500 earnings grew by 14%, largely driven by the energy sector, which saw profits rebound as oil prices stabilized. The rebound came after flat earnings performances in 2015 and 2016.
Kate Warne, investment strategist at Edward Jones, isn’t worried about the economic outlook.
“We are still seeing solid jobs growth and the economy is dominated by consumer spending. Since the economy has been growing at a 2% pace for the past nine years, there is no reason why it would not continue to do so in the tenth year,” Warne said.
“But high valuations mean that future returns would be more modest than the past returns that we grew accustomed to,” Warne said.
What surprises Warne in the current market is the lack of volatility. “We expected a pickup in volatility, given lots of political changes in Europe and in the U.S. and tighter monetary policy and are surprised that stocks are calm,” Warne said.
The Federal Reserve raised interest rates last week for the third time in a year and a half and policy makers are largely expected to raise rates at least one more time this year.
Some analysts compare low levels of implied volatility, as measured by the CBOE Volatility Index
to similar quiet periods in 2007, just before the start of the last bear market caused by the financial crisis. On Wednesday, the VIX fell 3% to 10.56, well below the historical average of 20.
The combination of low volatility and high valuations may indeed turn out to be a precursor for a large correction triggered by disappointment in economic or earnings data.
Warne is not worried about the prospect of a big pullback, however, saying that downturns are likely to be as short-lived as the previous ones, presenting a buying opportunity.
Dan Egan, director of behavioral finance and investments at Betterment, a robo-adviser, said the best way to deal with market turbulence is by having an investment plan that doesn’t require a strong viewpoint on how the market will perform in the short term.
“If your plan depends on where the market is going to be, then you will have a lot of disappointment,” said Egan.
“Using history as a guide for valuing the stock market and waiting for when the market is cheap would have forced you to stay out of the market since 2013 and miss the gains since then,” he said.
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