Opinions are increasingly divided on whether the ongoing bull market in U.S. stocks has more room to run, or whether valuations are so high that a correction—and a significant one at that—is all but inevitable. Unfortunately for investors, there doesn’t seem to be a clear answer, which makes asset allocation at this point particularly tricky.
There’s no question that in the past three to five years, buying into a universe like the S&P 500 has paid off. Consider that a fund like the SPDR S&P 500 (SPY | A-98) has delivered more than 63 percent in total returns in the past 36 months.
Chart courtesy of StockCharts.com
Looking back to when SPY bottomed out at the height of the credit crisis in March 2009 around $68 a share, it has now rallied an impressive 186.5 percent in the past five years or so. These gains have come thanks largely to an unprecedented quantitative-easing program from the Federal Reserve, but without significant economic growth.
In fact, U.S. GDP expansion remains muted even as interest rates sit at historically low levels, with the most recent quarterly reading pegging U.S. GDP growth in negative territory.
Valuations Are Sky-High
If you listen to experts like Nobel Laureate Robert Shiller, professor of economics at Yale University, you too might be “definitely concerned” about the prospects for a major downward correction.
In his most recent interview with Yahoo’s Daily Ticker today, Shiller pointed out that U.S. stock valuations—as measured by his CAPE ratio—are around 26, and have only been that high three times before:in 1929, 2000 and 2007. The historical average is around 17.
“The very low interest rates are a sign that maybe you want to keep more invested in the stock market now rather than getting nothing,” Shiller said in the interview. “It ought to help explain the high CAPE ratio, but that doesn’t mean that a high CAPE isn’t a forecast of bad performance.”
History shows that 1930, 2001 and 2008 weren’t particularly good years for U.S. stocks.
“We don’t know what the market is going to do,” Shiller said. “We could see a massive crash, but realistically, stocks should be in one’s portfolio, so maybe just lighten up [on exposure].”
Correction Maybe, Recession No Way
Some argue that a 10-20 percent correction is long overdue, even if such a downward move would not necessarily represent the beginning of a bear market. Those people include the likes of Sam Stovall, managing director of U.S. equity strategy for S&P Capital IQ, who says a correction is not out of the picture, but a recession is, because stocks are far from overvalued.
“Here we are in the final week of June, and people are still wondering whether the market is ready to roll over and go into a traditional downward spiral,” Stovall said in his latest market outlook during a webcast this week. “We are still in a bull market. From an economic perspective, our forecast does not point to a recession.”
Housing Starts, Yield Curve:Positive Indicators
On the contrary, he anticipates the U.S. and global economies will continue to grow in the next few years. One good indication of that is housing starts data.
“Seven of the last eight recessions were preceded by a 30 percent year-over-year decline in housing starts,” Stovall said. “In March, we were down 6 percent, so yes, we could be a little concerned, but we are well away from the threshold that in the past has indicated we were about to dip into recession.”
The yield curve is another source of optimism for Stovall, who points out that in seven of the last eight bear markets, the yield curve—as measured between the 10-year note and the three-month T-bill—was flat or inverted before we fell into a bear market.
“The market will let us know in advance if a recession is around the corner,” noted Stovall. “We are not there.”
Favorite ETF Picks For Rest Of 2014
For the second half of the year, Stovall is particularly positive on industrials—including transportation names—because these sectors are showing strength relative to the S&P 500. He said many investors have already been rotating into these segments lately.
- The Industrial Select SPDR (XLI | A-88) invests in industrial sector stocks drawn from the S&P 500 and has $10.7 billion in assets.
- The Vanguard Industrials (VIS | A-90) tracks a broad, market-cap-weighted index of U.S. industrial stocks and has $1.9 billion in assets.
- The iShares Transportation Average ETF (IYT | B-61) tracks a price-weighted index of transportation firms in the U.S. equity market selected by the Dow Jones Average Committee and has $1.2 billion in assets.
- The SPDR S&P Transportation (XTN | A-58) tracks a broad-based, equal-weighted index of U.S. stocks in the transportation industry and has $215 million in assets.
Meanwhile, consumer discretionary and financial sectors are showing “vulnerability” relative to the S&P 500 as investors rotate out of those sectors, Stovall says.