Proceed with Caution

I remember those eager first days in driver's ed class. The teacher drilled some basic principles into our heads and then, to drive them home even further, he would spontaneously quiz us and we would respond in unison, like a Greek chorus: "What do you do when you come to an intersection?" "Look left, look right, proceed with caution."  Apparently his methods worked; I still have his little voice in the back of my head when I drive, and when I come to an intersection it says "Look left, look right, proceed with caution." My teacher's wise counsel applies to many areas beyond driving. In fact, investors currently have at least three reasons why they should "proceed with caution."

Reason 1: Stocks are looking a little rich

Stock markets--especially in the United States and Europe--have had a very nice run this year. Through October 31, the S&P 500 index gained 25.3 percent year-to-date, while international markets rose 17.1 percent over the same period. However, it is interesting to note that these big price gains came even as earnings growth on S&P 500 stocks was rather tepid. Zacks estimates that 2013 earnings growth will top out at 6.2 percent, only slightly better than 2012. If we exclude recession years, 2012 and 2013 represent two of the slowest years of back-to-back earnings growth in the past 20 years. Clearly, valuations for stocks have been stretched. 

There are many ways to look at stock valuations. Several years ago, Robert Shiller, one of this year's Nobel Prize winners in Economic Science, introduced a concept called the "cyclically adjusted price earnings ratio" or CAPE. The CAPE ratio takes the current level of the S&P 500 and divides it by the index's average earnings per share for the past 10 years. Shiller claims that the long averaging period for earnings effectively smooths away the noise of economic cycles, giving investors a truer view of the stock market's relative value. The following chart showing the frequency distribution of the Cyclically Adjusted Price Earnings (CAPE) ratios since 1887 illustrates my point.

Based on CAPE, today's market looks rich. With Shiller's reputation stronger than ever, this measure is getting a lot of attention.

However, there are other ways to look at stock market valuation. One of the most prominent is to look at today's price relative to future earnings. Many believe this is a more useful measure since the stock market is a forward looking mechanism. In the spirit of full disclosure, I am in this camp. I don't usually spend a lot of time thinking about a stock's price relative to yesterday's earnings. I am much more concerned about what will happen tomorrow.

When evaluated in this light, the current market looks much more attractive. Most analysts expect earnings growth in 2014 to accelerate into the low double digits. As the following chart indicates, this pegs the stock market right at its long-term average valuation. We cannot say it is cheap, but it doesn't look overdone either. 

Reason #2: The Fed is looking wobbly

Love it or hate it, the Fed's easy money policy has been a boon to financial investors. Falling interest rates drove bond prices higher. Low bond yields pushed investors into stocks. And cheap financing encouraged leverage, thereby magnifying investor buying power. So what happens when folks begin to question the Fed's resolve to keep the money spigot wide open? That remains to be seen, but it seems fairly obvious that we should expect market turmoil much like we saw last June.

If you are worried about this, the Fed's recently released minutes from its October Federal Open Market Committee (FOMC) meeting provides little comfort. Those attending included all 10 voting members of the FOMC plus 54 other staff members. Much of the two-day meeting was spent wrestling over various ideas on how to begin unwinding quantitative easing and the other extraordinary measures of the past few years. The 64 attendees looked at it from many different perspectives and, in the end, did what many of us do when confronted with a perplexing conundrum--they punted. Here is the concluding summary from the actual minutes:

"At the end of the discussion, participants agreed that it would be helpful to continue reviewing these issues of longer-run policy strategy at upcoming meetings. No decisions on the substance were taken, and participants generally noted the usefulness of planning for various contingencies."

Huh? Not much of an outcome after 64 of our brightest economic minds kicked the problem around for two days. Fortunately, for now, inflation and economic growth are very mild, so the Fed can afford to be very deliberate in this process.

Reason #3: The changing of the guard at the Fed

The Ben Bernanke era is just about over and the Janet Yellen era is about to dawn. I thought Yellen did an admirable job spreading oil on potentially turbulent waters at her confirmation hearings. Still, every changing of the guard at the Fed is a big deal and the fact that this one comes right as we are worrying about a significant shift in the policy regime makes this one bigger than most. Fortunately, Yellen is a very bright lady and has long been an advocate for transparency and communication. Though the Fed may make a misstep or two in the transition to its new chairman, it is unlikely Yellen will intentionally blindside the market. I expect Yellen will consider any new policy direction very carefully and implement any change in a very measured way.

Where this leaves us

Sifting through these facts and conditions leaves me with three general conclusions. 

1. Market valuation is probably on the rich side of fair value. This means we are vulnerable to a correction, but it does not appear that the current situation is prelude to a significant bear market.

2. The Fed is going to begin unwinding its quantitative easing program sometime in the next few months. This is brand new territory for everyone and they don't really have a clue how to go about it. Fortunately, current economic conditions (i.e., lack of inflation and moderate economic growth) give the Fed some margin for error. Given her preference for open communication and transparency, Janet Yellen looks like a good choice to lead us through this transition period.

3. Though challenges persist and there is plenty of uncertainty, equity markets should move forward. As my driver's ed teacher would say, "proceed with caution."  

Steven Merrell, CFP®  is a co-founder and financial advisor at Monterey Private Wealth in Monterey, California.