Why? Because when prices are really cheap, the stories are absolutely awful. The flip side of the coin, however, is that when prices are cheap, expectations are low and with even the slightest improvement in sentiment, stocks can jump sharply. Remember back in January a year ago? The S&P 500 declined 4.9% in the first four trading days, the worst start to a year ever. But then a strange thing happened. The market started moving up in early February. The low expectations of the market were exceeded.
Today we are not at a market low. The stock market had a good year in 2016 and since November 8th the stock market has rallied 9%. So far the market has given soon-to-be-President Trump the benefit of the doubt. Wall Street is saying it is more likely Trump will be successful stimulating the economy and boosting GDP than it is that he will be the Trump of the primaries, where he might go off the rails at any moment.
Our take is that corporate profits will increase 5% to 8% this year, job growth will continue and consumer spending will stay strong. The problem, however, is that stock prices are not cheap. The chart below shows that when price to earnings ratios are low, below the long term average of 15x, future stock market gains are quite strong. Conversely when price to earnings ratios are high, future stock market returns are meager. We are somewhere around 17x to 19x on forward earnings today which implies a stock market gain of about 3% to 6%.
But things do not always go as planned. There can be quite a slip between cup and lip. Inflation may finally pick up this year and the Federal deficit could turn distinctly negative with increased spending and lower taxes. Also, the European Union may not hold together, and we just don’t know how Mr. Trump will get along (or not get along) with Mr. Xi Jinping or Vladimir Putin.
The one thing we do know, however, is that trying to time this thing doesn’t work. The chart below shows the increase in the S&P 500 over 10 year periods and the average return earned by investors. Investors don’t do as well as the market. One reason is investors get nervous at market bottoms and sell and then jump back in when prices are high. They simply don’t know how to go sit quietly in their room and let the ups and downs take care of themselves. We think 2017 can be a positive year, but the test will be whether investors can stay calm and remain fully invested when the winds and waves pick up. We intend to breathe deeply and stay as calm as we can.
