I’ve spoken with several reporters yesterday and today, all of whom are asking, “What is happening in the stock market?” In some respects, it is a little unreal—not that long ago, a market decline of about 1.25 percent was considered normal volatility. But given how the market has climbed almost continuously for the past several months, a decline like this has people asking questions.
Perhaps they should be. The market pause since the end of last year could be suggesting a couple of things investors ought to be aware of. If you look at performance at the end of 2013, you see a consistent run-up from October to early December, a pause while everyone worried about the Fed and the taper, and then a last burst of energy. Since then, it’s been bouncing around, but with a downward trend, exemplified by yesterday’s performance.
The first couple of weeks aren’t determinative of the year as a whole, certainly. But the change in tone is interesting, from the consistent gains of the past couple months to a wait-and-see attitude, a shift that coincided with the end of the year.
There could be (and no doubt are) multiple explanations, but what I think is going on is a reevaluation of where investors want to be. At the end of last year, with the strong performance, no professional investor could afford to be out of the market—imagine explaining to your clients how you missed the best year since 1997! This need to be in the market fed on itself, with new investment and window dressing right up to the close of the year.
Now, though, we have a clean slate. No one needs to be in the market, and you can see that lack of demand in the price action. Investors now have the time to step back, take a deep breath, and decide if they like what they see before jumping back in or deciding to pull back a bit.
There are reasons for caution. Starting with valuations, you can look at Yardeni Research’s excellent work, which shows earnings estimates for 2014 continuing to decline, per the following chart.
Lower earnings estimates, combined with higher prices, have pushed forward price/earnings ratios up to levels last seen in 2007. Looking at a longer history, the only time forward P/Es were well above this was in the run-up to the dot-com bubble.
You can argue that multiples can expand from here, and you would be right, but that expansion takes you into valuation levels that historically have been associated with bubbles. You can argue that earnings can grow into current valuations, justifying them, but you then have to argue that either revenues will increase by more than GDP, which doesn’t appear to be the expectation, or that profit margins will increase above current extremely high levels. It could happen, but that is what you’re betting on.
The other thing investors should be aware of is what has helped support earnings growth so far. Refinancing old debt at lower rates, and issuing new debt to fund share buybacks (which are actually expected to increase this year), has been a principal factor. By reducing the number of shares, earnings per share increase faster than company earnings do. This could be a support, if buybacks accelerate. At the same time, it’s hard to see how companies continue to issue new debt, at ever-decreasing interest rates, over the long term—especially if rates increase as the economy improves. It is also a fact that buybacks become more expensive, and less effective, as stock prices increase.
In short, looking at the market today with a clean slate, it is easy to come up with reasons to think it’s not cheap, and increasingly difficult to think of reasons it should move higher. This certainly doesn’t predict a decline, but it indicates that caution may be necessary. This kind of reassessment, which we’ve been seeing over the past couple of weeks, could be a healthy pause—or could lead to a correction as investors decide to pull back a bit. This, too, is something that history suggests is overdue.
Overall, the change in the market action over the past couple of weeks implies that, at least for a while, the air of optimism is taking a break. Combined with the unexpectedly weak employment report and the Fed’s decision to taper, it also suggests that this year might not be as good for the market as the last.