U.S. stocks: Where to from here?

November 7, 2017 Categories: Portfolio Corner
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With U.S. stocks seemingly setting new all-time highs every few days, it can be easy to overlook the fact that just nine years ago, markets the world over were roiled by intense market volatility. This memory prompted us to evaluate the status of the current bull market from a historical perspective: How does this rally compare to past U.S. expansions?

One of the most impressive runs of all time

The data is clear: At 103 months in length and boasting a cumulative return of 311% as of September 30, 2017, the current U.S. bull market (S&P500® Index) is the second longest and third strongest expansion since 1936, making it one of the most impressive runs in modern history.

As of September 2017.  Source: Morningstar.
S&P 500® Index – Quarterly Returns 04/01/1936 to 11/30/1987; Monthly Returns 12/31/1987 to 09/30/2017.
Expansions end after surpassing previously reached highs of the S&P 500 and a drawdown occurs of 10% or more.
Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.

These accolades beg the question:

What can investors expect going forward?

Impressive as it is, the current rally still has some ground to cover if it intends to match the longest and strongest expansion of 1946 to 1957, which lasted a whopping 131 months and had a cumulative return of 476%. However, that historical case is likely best treated as an outlier rather than as a measuring stick for how much steam today’s market run may still have.

Instead, valuations—specifically the Cyclically Adjusted Price-to-Earnings Ratio, or CAPE for short—offer a better assessment of the market’s remaining upside potential, in our view. Past bull markets can also be a guide. Let’s take each in turn.

What are valuations suggesting?

CAPE can be a helpful guide for measuring how cheap or expensive current stock market prices are relative to the amount of earnings they are generating. More importantly, examining the equity market’s historical levels of CAPE and subsequent returns can offer valuable lessons for potential expectations today.

The chart below illustrates this relationship between CAPE and subsequent three-year market returns going back to 1926. It divides the observed CAPE levels into three groups:

  1. “Cheap” Valuations (blue box): Market CAPE levels of 5–15
  2. “Average” Valuations (grey box): Market CAPE levels of 15–25
  3. “Expensive” Valuations (orange box): Market CAPE levels of 25–35

Yale Professor Robert Shiller calculates a Cyclically Adjusted P/E Ratio based on stock price divided by prior 10-year earnings. The stocks included are those of large publicly held companies that trade on either of the two largest American stock market exchanges: the New York Stock Exchange and the NASDAQ. The stock market returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.  

What can we learn from these different valuation levels?

  • Cheaper valuations historically have been followed by higher average equity returns for three years, with a less negative minimum return and more positive maximum return.
  • Expensive valuations have tended to yield lower subsequent average equity returns for three years with a more negative minimum return and less positive maximum return.
  • While “cheap” and “average” market valuations historically have had a high probability of delivering positive returns over the following three years, the range of returns in the “expensive” scenario has been much wider—and hence more uncertain—compared to other market environments.

As of September 30, 2017, the U.S. equity market has a CAPE of 30.7—putting it squarely in the “expensive” group.

It appears history is suggesting it may be time to reduce return expectations relative to the level many investors have grown accustomed to since the end of the Global Financial Crisis.

What lessons do past bull markets suggest?

How did the past bull markets listed in the first exhibit of this post fair over the following three years after coming to an end? Not surprisingly, the results aren’t too attractive. As you can see in the table below, the average return over the next three years was less than 5.0% and the average maximum drawdown was approximately -21.0%.

As of September 2017.  Source: Morningstar.
S&P 500® Index – Quarterly Returns 04/01/1936 to 11/30/1987; Monthly Returns 12/31/1987 to 09/30/2017.
Expansions end after surpassing previously reached highs of the S&P 500 and a drawdown occurs of 10% or more.
Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.

The bottom line:

Coming in as the second longest and third strongest, the current U.S. equity market rally ranks as one of the most impressive bull markets since 1936. While many investors undoubtedly have enjoyed the eight-year run, history suggests now may be a good time to diversify sources of return within investment portfolios. Russell Investments believes a globally diversified, multi-asset approach that can respond and adapt quickly to changing market environments has the potential to help navigate the subsequent vagaries of expensive markets.

Disclosures: These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

The S&P 500® Index is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500® are those of large publicly held companies that trade on either of the two largest American stock market exchanges: the New York Stock Exchange and the NASDAQ.

The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

The Russell logo is a trademark and service mark of Russell Investments.

Copyright © Russell Investments Group, LLC 2017. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

Russell Investments Financial Services, LLC, member FINRA (www.finra.org), part of Russell Investments.

RIFIS: 19445

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