10 January 2005
US equities ended the first week of January 2005 in the red. The Standard & Poor's 500 was down 2.1 percent, the Dow Jones Industrial Average was down 1.7 percent and Nasdaq was down 4 percent. However, if there is any reason to worry about US equities for this year, this is not it.
In a commentary for CBS MarketWatch on 4 January titled "What's so special?", Mark Hulbert questioned the significance of the performance of stocks in the first week of January.
He pointed out that over the past 108 years -- since 1896, when the Dow Jones Industrial Average was created -- there have been 72 years in which this market benchmark rose over the first five trading sessions of the year. On average during these years, the Dow rose 6.88 percent from the end of that fifth trading day through Dec. 31.
For the 36 years since 1896 in which the market declined over the first five trading days of the year, the Dow on average rose 6.98 percent thereafter through the end of the year.
Hulbert gave more compelling reasons to be concerned in a commentary titled "Stocks are not cheap" on the following day.
Citing research by Clifford Asness of AQR Capital Management and Anne Casscells, formerly the chief investment officer for Stanford University's endowment and now chief investment officer of Aetos Capital's absolute return business, he points out that the P/E ratio of 16.1 for the S&P 500 based on projected earnings was 46 percent higher than the long-term average. Using trailing earnings, Hulbert said that the S&P 500's P/E ratio of 20.6 was 50 percent higher than what the two money managers reported the median P/E to have been between 1871 and 2003.
As Hulbert puts it: "The S&P 500's current P/E ratio is either 46 percent above historical norms or 50 percent above. Your conclusion in either case should be the same: Stocks aren't cheap."
That does not stop others from issuing bullish forecasts.
A BusinessWeek survey of analysts near the end of last year found that the majority of them see a rise of between zero to 15 percent for stocks. A more limited survey by SmartMoney revealed six bulls and three bears.
In his latest commentary for SmartMoney, Donald Luskin of Trend Macrolytics sees "good things" ahead. He says that "we are in a strong economic expansion that has no reason at this point to lose steam. Orderly rate hikes through the rest of the year will help, not hurt".
Luskin was optimistic for 2004, and rightly so as it turned out. Whether his optimism for 2005 is correct obviously remains to be seen.
The rate hikes that Luskin sees coming is usually bad for stocks. It is possible that "orderly" rate hikes may mean something different, although Luskin does not explain how such hikes differ from normal ones.
Luskin also points out that while "S&P 500 earnings were up 23.6 percent in 2004, stock prices themselves advanced by only 8.9 percent. That means there's a lot of upside still to be captured".
My take on this is different. Stocks anticipate the future. If stock prices did not advance as much as stock earnings in 2004, that is probably because at the beginning of the year, prices had already discounted much of the year-ahead rise in earnings. There may not be much upside -- if any -- to be captured.
In my opinion, we are already advanced in the current economic expansion. While the economy is likely to continue to expand in 2005 and earnings are likely to continue to rise at a healthy pace, the risk of a weaker-than-expected economy while the Federal Reserve is on a tightening bias is real, especially as we approach 2006.
While some may argue that 2006 is still a year away, remember that stocks anticipate the economy by between six to nine months. And if Mark Hulbert is correct in saying that S&P 500 stocks are between 46 to 50 percent overvalued, the ensuing fall in stock prices may be large.
The time to turn defensive -- if not outright bearish -- may be closer than many people think.
Disclaimer: The commentaries posted here represent the opinions of the author at the time of posting and should not be taken as investment advice. Readers who wish to take any investment action based on information obtained from this site should seek appropriate advice from a qualified financial adviser.