Reports of sky-high market valuations bombard investors daily as the cyclically adjusted price-earnings ratio or Shiller P/E rises to levels it last reached before famous historical market crashes. Expensive valuations like these don’t have the power to start financial meltdowns, but they can exacerbate one if it comes.
The CAPE ratio often causes consternation because an astronomical ratio usually precedes or accompanies a famous market crash. Perched ominously at 30, the CAPE is higher than its pre-1929 Black Tuesday and financial crisis levels. It has also spiked higher only once, before the devastating dot-com bubble, to 44.2 in 1999. Worse, the CAPE averages 17 historically.
Tomer Cohen of Five Roads Capital says a high CAPE makes him cautious because it signals increased risk in markets. The current lofty reading, the result of a market with low volatility and high prices for 18 months, are prompting investors to “become optimistic and push up valuations beyond reasonable levels,” he says.
[See: 7 Ways to Tell if a Stock Is a Good Price.]
Typically, what happens in these cases is an external catalyst comes along, acting as a “pinprick to bubbly asset valuations,” and stocks have a long way to fall, says Nathan Edwards, a certified financial planner at IMG Wealth Management in Jacksonville, Florida. In 2000, the precipitating event was collapsing share prices of dot-coms in the tech sector. In 2008, trouble arose in the housing market.
So which match might torch high valuations in the current market now? There are several possibilities, including the chance that nothing will stop the market’s torrid rise — not yet, at least.
Catalysts for a correction. A slowdown in earnings, the lifeblood of the market’s years-long rise, could spur tremendous damage, but earnings of U.S. companies fared exceptionally well in the second quarter, with the Standard & Poor’s 500 index climbing 10.2 percent, the second highest year-over-year growth since the fourth quarter in 2011. It was also the first time the index had two consecutive quarters of double-digit earnings growth since the third and fourth quarters of 2011.
The possibility of a stall seems unlikely to Edwards, who believes low interest rates, which encourage capital investment, will continue to bolster earnings, though Federal Reserve Chair Janet Yellen has hinted at the possibility of a forthcoming rate hike.
Though strong earnings can linger for some time, eventually they will fall into line with reasonable growth expectations. As of Aug. 11, 63 percent of S&P 500 companies that had issued guidance reported negative forecasts, short of the 75 percent five-year average. If earnings slow down, it won’t be in 2017, as analysts project 9.4 percent growth for the full year.
Tech stocks, with their dominance in the market, are a concern as well. “Our current economy and stock market is more globally sensitive and more technology-dependent than in previous eras,” says Temple University business law professor Tom Lin, who notes that 10 tech companies contributed half of S&P 500 gains for the year. Facebook ( FB), which has a P/E ratio of 36.5, and Netflix ( NFLX) with a P/E of 210 led the list.
Rising inflation also could set off sparks. “Higher inflation (possibly labor driven) would increase bond rates to more competitive levels and increase debt burdens enough to reduce economic expectations,” Edwards says. While inflation rates have been falling each month from February through June, July’s rate jumped to 1.73 percent, the highest level for that month in three years.
[Read: How to Play Income Investments When Rates are Rising.]
Then there’s heightened tensions and the possibility of armed conflict with North Korea, which might toy with investor psychology, triggering a sell-off. That may already be happening. Trump’s threats of “fire and fury” against the authoritarian, militarized nation drove a 1.64 percent decline in the S&P 500 that week.
Without a catalyst, the market also could revert to more reasonable prices gradually, potentially allowing years of further gains. For instance, the CAPE ratio touched today’s elevations in 1997, but three more years of gains passed before a downturn occurred in September 2000.
Stick to the basics. As markets get riskier, predicting when a correction will strike is anyone’s guess, but this is where tried-and-true investing strategies pay off.
Venture capitalist Paul Arnold, founder and partner of San Francisco-based Switch Ventures, recommends investing in companies with real revenue, good margins and attractive valuations. “Essentially, real businesses and bets that can weather a downturn,” he says. International Business Machines Corp. ( IBM), for example, has dropped 14.5 in price percent year-to-date and has an attractive 11.8 P/E ratio, and Intel Corp. ( INTC), which declined 1.2 percent, trades with a P/E of 13.7. “It sounds simple, but these fundamentals are forgotten by many,” Arnold says.
A diversified portfolio can also enhance protection, says Kajal Lahiri, professor of economics at the University at Albany. He suggests investing in stocks and real estate, as well as government and corporate bonds, because of the uncertainty about policy from Washington. He also recommends exchange-traded funds, reputable mutual funds and exposure to China through U.S. companies that will benefit from China’s global infrastructure investment, such as Caterpillar ( CAT), Honeywell International ( HON) and General Electric Co. ( GE). All do business in China and are “smart bets for the medium run,” he says.
[See: Chinese ETFs: 9 Ways to Play the Middle Kingdom.]
“Tricky and volatile times are ahead because some correction in the stock market is inevitable,” Lahiri says. “When the federal government is dysfunctional, stocks soar, but not without gyrations.”
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What Might Start a Market Meltdown? originally appeared on usnews.com
