Midyear Outlook for Stocks

6/20/2016


Heading into the second half of 2016, we're not convinced the primary trend is bullish. The S&P 500 Index has merely rallied back to levels where it has stalled several times since its May 2015 all-time high. The Dow Industrials are more than 2% from their April 20 closing high of 18,096.27, while the Dow Transports sit more than 6% below their April 20 high of 8,109.19. Until the averages start reaching significant highs, we won't adopt a fully invested posture.

But we'd rather own stocks than bonds, partly because earnings yields (earnings/price ratios) are unusually high relative to bond yields. The median trailing earnings yield for S&P 500 stocks is roughly 5%, about 3.3% higher than the yield on 10-year Treasury bonds. That spread is wider than 82% of month-ends since 1994 — and well above the norm of 1.3% since 1994.

Also, much of the market's overvaluation is concentrated in the least-volatile stocks. Only two of the S&P 500's 10 sectors have reached all-time highs this year — the defensive consumer-staples and utilities groups. As money has poured into funds targeting dividend payers and low-volatility stocks, such stocks have become expensive relative to historical norms. As shown on below, the least volatile one-fifth of stocks in the broad S&P 1500 Index is more expensive on P/E ratio than it has been since at least 1994 — its premium to historical norms is higher than that of other stocks.

Low-volatility stocks become expensive
For most of the past 21-plus years, less-volatile stocks have traded at lower price/earnings ratios than more-volatile stocks. But low-volatility stocks, after outperforming handily over the last five years, now trade at premium valuations. In fact, the least-volatile one-fifth of S&P 1500 stocks now has an average trailing P/E of 24 (excluding P/Es above 75 or below 0), 29% higher than the norm since 1994 and higher than 100% of month-ends since 1994.
Average P/E Ratio For S&P 1500 Stocks Grouped By Standard Deviation
Least
Volatile
Second
Quintile
Third
Quintile
Fourth
Quintile
Most
Volatile
Recent average P/E *
24.0
22.2
21.2
22.9
21.8
Norm since 12/94 *
18.7
20.4
20.8
22.3
24.6
Recent as % of norm
129
109
102
103
88
% of months lower with
lower avg. P/E since 12/94
100
76
59
58
22
* Excludes P/Es above 75 or below 0

What to do now

Do you think corporate earnings growth will revive as the effects of a strong dollar and crashing oil and commodity prices abate? Or do you think earnings are in an extended funk, with expectations for a second-half rebound in profit growth mere wishful thinking?

In large part, your stock-market exposure should hinge on the answers to those questions, for shares of companies with even modest cyclical exposure appear reasonably valued. Profit-estimate trends provide reason for optimism, as the number of companies warning on profits has dropped from recent levels.

Still, before lowering our cash position much further, we'd like to see confirmation from the major averages as well as the Dow Transports and other cyclical stocks. For now, our buy lists have 16.5% to 17.2% in a short-term bond fund. With the remainder, we're emphasizing attractively valued shares of quality companies.


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