Don't Sell Yet


No matter how bullish you are, listening to the arguments of the bears makes sense. Getting locked into a particular mindset is among the most dangerous things you can do as an investor, so you always want to consider how you might be wrong.

With the Dow Transports, Dow Industrials, and nearly all major U.S. and global benchmarks reaching new highs in recent trading, the U.S. stock market's bullish primary trend is hard to dispute — especially with broad measures like the S&P 1500 advance-decline line also reaching fresh highs.

The bears, for the most part, are left with two arguments.

Investors are too bullish. When nearly everyone is bullish, it suggests little money remains on the sidelines to push prices even higher.

The bears have grounds for concern. At 60%, the percentage of bullish investment newsletters has re-entered the "danger zone," says Investors Intelligence. The Wells Fargo/Gallup Investor and Retirement Optimism Index reached a 17-year high in September.

Stocks are too expensive. In the late stages of major bull markets, stocks sometimes advance on mere hopes and expectations, reaching valuations that look extreme in hindsight.

The S&P 500 Index trades at nearly 18 times expected year-ahead earnings, above the 10-year average of 14.1, according to FactSet. The Shiller P/E, based on inflation-adjusted earnings over the trailing 10 years, is above 31 — higher than at any time except the market peaks of 1929 and 2000.

Historical norms

While both arguments have merit, that does not mean the bears' predictions of certain doom are correct. For one thing, nothing is certain when it depends on the actions of humans. For another, today's sentiment and valuation readings may not be as ominous as the bears assert.

Unusually bullish sentiment means the market has little protection against a downside surprise, such as a disappointing earnings season. But that does not mean the downside surprise will definitely happen, and sentiment can remain elevated for extended periods as stocks move higher.

Moreover, today's sentiment readings are not uniformly extreme. The AAII survey of individual investors puts the percentage of bulls at 40%, in line with historical norms. The Investors Intelligence bullish percentage has exceeded 60% in the early or middle stages of several bull markets over the past 30 years. The Wells Fargo/Gallup survey showed that more than half of U.S. investors expected a decline this year that will wipe out "significant gains."

Regarding valuations, the median trailing price/earnings ratio for stocks in the S&P 500 Index is 21, about 15% above the norm of 18 since 1994. For the capitalization-weighted S&P 500 Index, the trailing P/E of 25 compares to the 20-year average of 26 and 50-year average of 19. Triple-digit P/Es during the financial crisis skew the 20-year average, so the 20-year monthly median of 22 may be more relevant.

The Shiller P/E is also impacted by the very weak earnings recorded in the financial crisis. As a result, the Shiller P/E has pegged stocks as overvalued since at least 2010. Based on five-year trailing earnings, the Shiller P/E would be 26, slightly above the 20-year average of 25 and well above the 50-year average of 19.

Are 50-year averages relevant? That depends on your outlook for interest rates. Over the last 50 years, yields on 10-year Treasury bonds averaged 6.5%, compared to today's yield of 2.3%. Today's trailing earnings yield (E/P ratio) for the S&P 500 Index exceeds the 10-year Treasury yield by 1.6% — well above the average spread of 0.7% over the past 20 years and 0% over the past 50 years.


Investor sentiment is a bit frothy, and valuations are rich. But valuations still remain attractive relative to bond yields, and the primary trend is squarely in the bullish camp. All things considered, selling now seems premature. Our Focus List and Buy List have 100% in stocks, while our Long-Term Buy List has 94%.

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