Our Plan For The Year Ahead


You can slice the data many ways and spin it even more ways, but there's no denying that stocks are expensive — unless you measure them relative to current bond yields. Some supporting evidence:

• Only 12% of stocks in the large-company S&P 500 Index have trailing price/earnings ratios below 14 — well below the norm of 25% since 1994. The percentages are similar for the broader S&P 1500 Index, with only 12% trading at P/Es below 14 compared to the norm of 24% since 1994.

• For all 10 sectors of the S&P 1500 with data back to 1994, the current median P/E is higher than the 22-year norm. All except consumer discretionary and technology are at least 13% higher than the norm. 

• The median P/E for both the S&P 500 and S&P 1500 is about 21, some 16% to 18% above the norms since 1994. Stocks are even more expensive based on other measures; median price/sales ratios for both the S&P 500 and S&P 1500 are higher than they've ever been since 1994, with current levels more than 40% above the norms.

• The median earnings yield (E/P ratio) for S&P 500 stocks is nearly 4.8%, below the norm of 5.7%. But the current earnings yield is 2.3% higher than the 2.5% yield on 10-year Treasury bonds. That spread, though down from 3.5% on Sept. 30, is higher than the average spread of 1.3% since 1994.

When the Federal Reserve raised short-term interest rates by 0.25% on March 15, it signaled that it expects two more rate hikes before year-end. With inflation indicators also rising, many expect long-term bond yields to climb over the next year. All else equal, for the spread relative to the S&P 500's earnings yield to equal the 22-year norm, the 10-year Treasury yield would need to climb to 3.5%.

All else is never equal. If interest rates rise because the global economy is finally firing on all cylinders, improving expectations for corporate earnings will counter the impact of higher bond yields. But if interest rates rise on inflation worries and profits stagnate, stocks are likely to suffer.

Our game plan

Even if one concedes that stocks are expensive and bond yields are headed higher, it's tough to know how stocks will perform over the next year. Many expect a final surge, a speculative frenzy. History suggests that is possible, but we're likely to have one foot out the door if we see that happening.

However, if we see stocks advancing on encouraging earnings news, we're likely to maintain a mostly invested posture unless the Dow Industrials or Dow Transports stop reaching fresh highs. For now, our buy lists have at least 94% in stocks.

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