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Broad stock market indices are reaching new highs, seemingly on a daily basis. Many analysts are puzzled, lamenting extremely high stock valuation levels as compared to historical norms as well as uninspired economic growth rates. The S&P 500 currently sells at a price-to-earnings multiple of 25.7 times, well over its mean over the past 100-plus years of 15.7 times.
More and more pundits are calling for an inevitable correction in the “frothy” stock market. The term “bubble” appears quite often in the financial press. What is driving the market? What factors could lead to a market downturn?
Robust consumer and business community confidence buoy the current market. The rise in confidence is largely attributed to the actions and plans of the business-friendly Trump administration and more favorable business regulatory environment than existed during the Obama years.
The Conference Board’s Consumer Confidence Index now stands at 118.9, substantially higher than the average of 77.1 between 2008 and 2016. Further, the percentage of consumers who believe business conditions are “good,” as defined by the index, increased from 29.8 percent in May to 30.8 percent in June.
Likewise, the percentage of respondents who believe business conditions are “bad,” decreased from 13.9 percent in May to 12.7 percent in June. Because 70 percent of the U.S. economy is a result of personal consumption, or consumer spending, the sentiment of those consumers matters.
The small business community is also extremely enthusiastic. The National Federation of Independent Business (NFIB) Small Business Optimism Index stood at 104.6 in May. For historical context, the index remained above 104 for the sixth consecutive month. Since 1975, the index has averaged 97.9, reaching an all-time high of 107.7 in July 1983 and a record low of 80.1 in April 1980.
One group that is not very confident about the direction of the market over the next six months is individual investors. But this can actually be good news for the market. For the week ending July 5, The American Association of Individual Investors (AAII) Investor Sentiment Survey found that only 29.6 percent of respondents were bullish in a survey of its membership.
The average since 1987 is a bullish reading of 38.3 percent. Such a low bullish reading might concern some individual investors, but some clarification is warranted. Bullish sentiment reached its highest level at 75 percent in early January 2000, during the height of the technology bubble. Bearish sentiment reached a record high of 70.3 percent in early March 2009, when the market bottomed in the throes of the financial crisis.
You see, the AAII Investor Sentiment Survey is considered by many to be a contrarian indicator (when bullish sentiment is low the market tends to rise). According to AAII Vice President Charles Rotblut, “Extraordinarily high bullish sentiment and extraordinarily low bearish sentiment…have generally worked well [as contrarian indicators].”
The biggest factors that could influence the stock market in the second half of 2017 are interest rates, corporate earnings, and geopolitical events.
In an interview with Yahoo Finance’s Andy Serwer in April, Warren Buffett was quoted as saying, “Everything in valuation gets back to interest rates.” Following the Berkshire Hathaway annual meeting, he told CNBC’s Becky Quick, “If these rates were guaranteed to stay low for 10, 15, or 20 years, then the stock market is dirt cheap now.”
Simply put, if rates rise substantially, the stock market rally could be reversed. You see, stocks and bonds compete for investor dollars and are the key to pricing financial assets. If interest rates are low, higher stock prices can be justified.
Secondly, corporate profits have been growing at the highest level in over five years. If corporate earnings growth were to significantly weaken, that certainly would put pressure on stock prices. According to Thomson Reuters, second quarter earnings are expected to increase 8 percent over the second quarter of 2016.
In addition, of the companies in the S&P 500 that have reported earnings for the second quarter, 78 percent have reported earnings above analyst expectations. This is above the long-term average of 64 percent.
Finally, the market dislikes uncertainty and significant geopolitical events — like the specter of a military conflict in North Korea or a major terrorist event — would certainly roil the markets.
The bottom line is that current stock market valuations do not seem incongruent with the data. But as an avid Buffett follower and Berkshire Hathaway shareholder, I think his quote on stock market predictions — “We have long felt the only value of stock forecasters is to make fortune tellers look good” — is relevant.
Moreover, his views on trying to time the market are critical. Waiting for a better time to invest and trying to guess what the market is going to do in the short run, according to Buffett, is a losing game.
Robert R. Johnson, PhD, CFA, is president and chief executive officer of the American College of Financial Services. He is co-author of Strategic Value Investing, Invest with the Fed, and Investment Banking for Dummies.
The views expressed by contributors are their own and are not the views of The Hill.