Sunday, November 17, 2013

How high can it go?

I've recently been hearing a lot of discussion about an impending market correction or even crash. The prophets of doom have the numbers on their side: the S&P 500 has advanced some 25% so far in 2013, but corporate earnings have advanced only 3%. Simple logic tells us that this means the market is pushing the price-earnings ratio higher.

At some point, we will face 'reversion to the mean,' as historically, P-E ratios have averaged 14-15% and are now, depending on the metric one uses, in the neighborhood of 19-24%, i.e., far above their historical mean.

And yet . . .

The collective consciousness of the market could be right in pushing vauations so much higher in the absence of YTD growth. For one thing, if GDP growth begins to accelerate more quickly as we head into 2014, corporate earnings should grow to echo that GDP growth. Thus, what may now seem like historically high P-E ratios may soon appear closer to historical norms if the 'E' in the ratio increases. The collective consciousness of the markets tends to price in where it thinks the markets will be in 6-12 months.

So the market is pricing in continued growth (and acceleration in growth) of earnings.

But if the market is wrong . . .

A reversion to the mean could spell a very sharp correction in the near-term. It has been over 570 days since the markets have experienced a 10% correction but history tells us to expect one every 350 days or so. Again, 'reversion to the mean' comes to mind. If earnings do not grow as fast as anticipated or even decline, then the 'P' in the P-E ratio will decline to bring said ratio into conformity with historical norms.

As for myself, I have begun to trim back equity positions in large- and small-cap growth and have rotated some of those funds into value components and into bonds. Right now, I have about 48% in equities and about 52% in bonds and cash. If the market continues to ascend, I'll continue to trim equities into the rally and add to fixed-income and cash positions. As far as rotating back into equities, I'm now waiting for at least a 5% correction to take any decisive actions as far as augmenting my equity positions.

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