There is a lot of angst in the financial news about an impending stock market decline. These range from concern about a “correction” to an out right crash, a la 2008. The general concern is the stock market is over priced relative to the earnings the underlying companies are generating. Annual growth in corporate earnings for the companies in the S&P 500 has slowed in the last couple of years, and with the Federal Reserve on the verge of raising interest rates for the first time in nine years, analysts suspect the stock market is vulnerable. Higher interest rates could put pressure on corporate earnings, potentially slow economic growth and would present a more attractive alternative to the stock market than is currently the case.
First, is the stock market over priced? The current price to earnings ratio (P/E) on the S&P 500, a common measurement of market valuation, is a little over 20 based on first quarter earnings annualized. Using analysts projections of 2015 earnings, the ratio is a little over 18. The ten year average P/E ratio for the S&P 500 using actual 12 month earnings (vs analyst projections) is a little over 17, and the twenty year average P/E ratio is about 20.5. So at between 18 and 20, depending on assumptions, the market P/E is on the high side of average, though I would not say the market (as represented by the S&P 500) is very over priced.
Second, is the stock market vulnerable? Sure. The market is sensitive to all sorts of things and fluctuates widely based on global news. I would say the stock market is always vulnerable. The Federal Reserve is expected to raise interest rates in the near future, but the economy is growing only slightly faster than anemically and inflation is below where the Federal Reserve would become concerned. So a rapid rise in interest rates that would damage corporate earnings or economic growth is not likely.
Third, who cares? The stock market on average has a down year one in every four 12 month periods. It has never not recovered. In 2000 to 2008, we had more than our share with three big calendar year losses, two of which were back to back (following the tech bubble). But even with these, the stock market regained it’s footing. In some cases it takes longer to recover than others, and if your planned cash flow is tied up in the stock market during a down year, that is a problem and a loss that can’t be recovered. However, if you treat the stock market as a long term investment, there is no reason you cannot ride out the downs as well as the ups.
A good rule of thumb is to invest only money that you won’t need for at least ten years in the stock market. Historically speaking, the stock market has a low likelihood of being down over a ten year period. Money that you may need sooner should be invested in less risky investments like bonds, which have a low likelihood of being down over three year periods or money market funds which present a very low likelihood of loss ever. That makes stocks a great investment for retirement savings, regardless of today’s valuation, if you have more than ten years before you start drawing down your account. It makes stocks a lousy investment for your emergency fund, the money you’re saving for the down payment on your house, or the money you will draw down from your retirement account over the next ten years.
I’m convinced timing the market is impossible. Those who have been successful have been lucky, and there is no evidence that anyone can consistently do it. So why worry about whether the market is over valued? Over the long term stocks are a good bet and an important investment if you are going to be financially secure and independent.