The Market: March 2014

As we move through March, the bull market seems very much intact.

Recent manufacturing reports were strong and after two months of soft numbers, the employment picture seems to be firming up. The S&P500 recovered from its January decline to make a new high on March 7th.

Earnings season for the 4th quarter is behind us and the overall result was ok. As of March 14, according to FactSet, of the 495 companies in the S&P500 that reported, 71% have reported earnings above the mean estimate and 62% reported sales higher than the mean estimate.

While 2013 ended with these solid profit figures, 89 companies have issued negative guidance for profits in the 1st quarter of 2014. Winter weather is a consistent reason for 1st quarter corporate pessimism. We will have to monitor the numbers that will start to come in April to see if the weather really impacted business conditions.

For now, the current 12-month forward P/E ratio for the S&P500 is 15.2. This is higher than the 10-year average of 13.8 but not dramatically so. Consumer Discretionary stocks within the index have the highest P/E of 18 while Telecoms and Financial have the lowest at 12.6 and 12.7, respectively.

While the overall S&P500 P/E is above the 10-year average, history has shown us many instances where P/E ratios were much higher. This of course doesn’t mean that those high P/E periods ended well. In the late 1990s during the tech run, the S&P500 P/E was around 30. At the end of 2007, before the housing crisis, the P/E was about 22. So before a bull run ends, P/Es can go to pretty high levels.

Speaking of bull markets and their endings, I have been through four major bull markets – 1982 to 1987, 1987-2000. 2002-2007 and 2009-now. It seems that the present bull market has the most doubters and the most willing to declare it a bubble. Jeremy Grantham of GMO is a student of market bubbles and was interviewed in this week’s Barron’s. Based on his historical work, he defines a bubble as a market that is at least 2 standard deviations above its long-term trend line. Presently, with the S&P500 at 1,860, the market is only 1.5 standard deviations above trend. The market index would have to rise to 2,350 to be at the two standard deviation level. That’s a 26% increase from today’s level.

As an aside, Grantham calculates that housing at the 2007 peak was 3.5 standard deviations above the long-term trend for home prices. The larger the distance from the trend, the bigger the fall back to it. Most of the time, once a bubble bursts, prices don’t stop at the trend line. They fall below it. However, we are not there yet and the bull could run for a while before we face the issue of a bear market.

While institutions seem to be back in the stock market, the individual investor has been reluctant to take part. The last phase of a bull market is characterized by the “little guy’s” euphoria. Be on the lookout for tips from the shoeshine guy.

— Ian Green, Pendragon Capital Management

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Note: This blog article is intended for general informational purposes only. Nothing in it should be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product.