The reason to be cautious in the market today is not due to lack of growth. The (projected) growth is there, however, investors are paying a premium for this growth at an unsustainable rate.
Three primary risks in the market today:
Risk-free (treasury yield) is increasing, dynamic yield curve flattening.
You are paying a premium for growth in sales and earnings.
A fool’s market
Case One: Risk-free (treasury yield) is increasing, dynamic yield curve flattening
10-year T-Bill Yield, image source: www.multpl.com
In the above chart, the risk-free rate 10-year treasury yield is just starting to creep upwards.
When looking at the dynamic yield curve above, notice the flat red line just prior to the recession in 2008. The yield curve is starting to flatten today signaling a potential market correction (look below).
Below is how the yield curve looks in a growth market.
Case Two: Paying a Premium for Growth
For the first time in many years, you are paying a Price to Sales ratio of over 2.0. Sales are increasing in many stocks across the S&P 500, however, you are now paying a premium for that growth. In fact, you are paying twice as much for those same sales compared to 2009.
From an earnings perspective, investors are also paying a hefty premium. The S&P 500 “Shiller P/E” ratio which is the average inflation adjusted P/E ratio from the previous 10 years is also high at nearly 33. The normal P/E ratio for the S&P 500 is 24 versus a long-term average of 16. If you look at the PEG ratio (PE / EPS Growth) you won’t be able to find many quality stocks at a bargain. One example of a bargain stock we own in our Wide-Moat Profitable Growth Portfolio is TD Ameritrade (AMTD) which has a PEG of 0.55. Typically, you want to find companies with a PEG ratio under 1.5 to signal you are not overpaying for the earnings growth. If we were to divide the “Shiller PE” by the S&P 500 earnings growth rate of 15%, we’d arrive at a PEG ratio of 2 for the S&P 500 which is above a long-term average of 0.9.
Case Three: A Fool’s Market
Admittedly, I consider this final argument a bit speculative, but you can see the data and conclude as you like.
First of all, the raw interest in the search term “S&P 500 Index” (all charts below from Google Trends only US) has increased considerably. The search for “P/E” has declined indicating a potential lack of interest in a very common valuation metric. The search for “growth stocks” has risen considerably supporting the fact that investors are searching for growth and are less concerned about what they pay for it.
If you were to sit on cash and try to time the market, Peter Lynch proved that even if you bought stocks at market highs, the US stock market has always recovered and then some. In fact, consistently buying stocks has always been proven to outperform those who try to time the market by exiting and trying to enter at what they feel is an “opportune” time.
The market is due for a correction, many people know this, however no one knows when it will happen (myself included). The most important thing you can do is remain invested in quality businesses that have wide-economic moats. During market down cycles, strong businesses can often take advantage of these periods to find bargain buys, find ways to improve and cut costs, and take share from competitors. Now more than ever it is important to be extremely selective with your individual stock holdings.
Thanks for reading!