Dow 40,000

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We’d like nothing more than to see the Dow continue its ascent and double yet again. Maybe this is the greatest bull market in history and the market will push higher and higher over the next few years? It’s already the second longest and third strongest bull market in history. And valuations were this rich in 1997 but the market continued its run until the dotcom bubble burst in March of 2000.

Yet after eight years of strongly advocating for stocks, we are feeling cautious on the market. From early 2009 (see our commentary Could It Be?, March 14, 2009) through Brexit (see our commentary, Brexit in Context, June 27, 2016), we suggested an overweight position in equities. Our enthusiasm for stocks has been unambiguous. Often these views were unpopular, especially in the early stages of the bull market. We argued for stocks during periods when many panned them.

We have no idea when stocks will falter and we recognize that the current positive market momentum is a powerful force for further gains. However, a day of major retracement is likely in our future and forward returns will probably be modest as a result.

In this note, we will attempt to make two points: 1) the present psychology is indicative of the last leg of a bull market (investor exuberance) and 2) forward ten-year returns will be below average (extreme valuations).

Of these two points, we are highly confident. It is impossible to know, however, when the gains will slow or cease. It’s party time and investors are belly up to the bar; when they pass out is anyone’s guess.

As to psychology, equity prices typically “climb a wall of worry.” Stocks forge ahead from low valuation levels while investors fret about everything imaginable (Fed policy, European banks, unemployment, hyperinflation, deflation, Greece, flash crashes, debt ceilings, high frequency trading, etc.). Contrast that with today when valuations are high and investors focus only on good news (low unemployment, strong consumer sentiment and business confidence, tax cuts, infrastructure spending, deregulation, etc.). It’s been an amazing metamorphosis.

As with any bull market, many investors missed the early gains because they were focused on the above problems. As these folks now enter the market, they seek reassurance that stocks have room to run. Wall Street and the media are more than happy to oblige. Crisis sells, but euphoria also sells.

Most of the market analysis we’ve been reading of late is entirely focused on how policy coming out of Washington (deregulation, tax cuts and infrastructure spending) could propel sales and profit growth. On the other hand, few analysts are discussing the steep price investors are paying for potentially stronger future growth. To put it simply, the market is priced for perfection. If things don’t go exactly right (they rarely do), the market will one day react negatively.

The most common way to value the market is the price-to-earnings ratio (P/E), which is how much an investor pays for each dollar of earnings. With a trailing P/E of 27 according to Barron’s, an investor is paying $27 for every dollar of earnings.

If the P/E ratio reverts to its long-term average of 15 over ten years, this implies a headwind to returns of -5.71% per year. Markets are not generous enough to parse out such a headwind over time. Rather, volatility should eventually increase markedly and long-term stock investors will experience major setbacks along the way.

Taking all of this into account, it is still impossible to time the market. Remember the above example of 1997, when stocks were similarly overvalued, but investors who bailed would have missed huge returns over the following three years. As we’ve cited in past updates, investors who miss the best months and years do major damage to their long-term returns. So, the prudent thing to do right now is to reduce equity exposure marginally and to then stay absolutely committed to one’s stock allocation no matter what happens to the market, no matter when it happens. And, finally, when the market falls, be prepared to rebalance by purchasing stocks. When that times comes, the public and the press will surely loathe stocks once again.

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