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As the stock market continues to reach new highs, I’m hearing more discussions and debates from investors to analysts about when it’s expected to top out.
In fact, many clients at Glassman Wealth Services are asking this very question. While I don’t presume to predict the tops or bottoms of markets, here are 4 reasons why I believe the stock market hasn’t reached its peak that are worth considering:
1. Rolling Correction: Value Stocks Replacing Growth Stocks
I believe the markets are in the midst of a rolling correction, hidden by the strength in the S&P 500 and Dow Jones indices. Larger companies, which have the greatest weightings in these indices, are obscuring what is truly going on beneath the surface – a rotation out of more expensive growth stocks to more reasonably valued stocks. This rotation can be interpreted in one of two ways: Either this is healthy or there is more trouble to come.
Source: JPMorgan Market Insights
From what I’m seeing, this looks healthy, with investors moving out of the most expensive speculative stocks like Twitter into larger, less expensive companies, like Exxon Mobil. This can be seen below in the year to date returns through the end of May. Returns are strongly positive in large and mid-sized companies, (think S&P and Dow), but broadly negative for smaller companies.
Year to Date (YTD) US Equity Returns as of May 31st
Returns by market segment (e.g. LV = Large Value, SG= Small Growth, MB = Mid Blend)
2. Earnings – Investors May Pay More for Less:
Last quarter’s earnings were decent but not great. The earnings growth rate in Q1 2014 was only 2.1%, and out of the 490 S&P 500 companies, 74% reported earnings above expectations with only 53% reporting sales above estimates. Looking forward, 79 companies issued negative earnings (EPS) guidance while only 26 companies are predicting positive earnings for Q2. (Source: Factset Earnings Insight)
For the market to move much higher, we will likely need accelerating earnings in the back half of the year. Without a big increase in earnings, higher stock prices can only happen if investors are willing to pay even more for current, tepid earnings.
3. Consistent Mid-Term Election Year Market Conditions:
Also, historically the 2nd and 3rd quarters of a mid-term election year are weak and choppy for the markets. This is consistent with what’s now going on now and suggests higher stock prices in Q4 of this year.
Source: Strategas Research Partners
4. Stable Credit Markets:
The credit markets aren’t yet flashing any signs of stress in the system. Credit availability is very good, especially for non-investment grade companies that can access credit at very low interest rates. As long as credit is readily available and markets believe that companies can repay their debts, this should provide a stabilizing effect for the equity markets.
Source: Bespoke Investment Group
Summary:
The rotation we’re seeing is healthy for the stock market. It’s letting the market digest last year’s rapid increase in stock prices as earnings catch up to valuations. For now, the market appears to be in wait and see mode about future earnings and increasing US economic growth. As such, I expect choppy markets for the next couple of months. Ultimately, this may turn out to be a year without clear direction, but one where equities still generate mid-to-high single digit returns.
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