As the market reaches new highs, investor fear increases. Much of this relates to a focus on price without regard to what has happened to earnings and the economy since the 2000 era. How should the investor consider this? Is the story different for traders?
One approach is to consider the downside risk. This means more than just speculation about recession odds and the other elements of the Bear Playbook. While no one can say with certainty what will happen with equity markets, there are ways to get a handle on the probabilities.
The Intermediate Time Horizon
Many investors and their managers operate on a time horizon measured in months, not days. There is a lot of discussion about short-term market moves and sentiment indicators. We are interested in a longer term sentiment measure. The forward market P/E is good for that purpose.
We use the cap weighted S&P 500 for this purpose because that is the vehicle for the millions of investors who buy index funds or closet index funds. We use forward earnings because we are trying to predict.
When the forward earnings yield on the S&P 500 is 6.7% and the ten-year note is about 4.5%, that shows a high level of skepticism about earnings. You can call it a risk premium, but if so, it is a big one. It shows that the powerful voices of market bears have been heard. Over half of the country thinks we are in a recession or about to be. A recent online poll of investment advisors(!) showed over 25% expecting a 1987 style market crash. Wow!
Gary D. Smith calls this a negativity bubble and we agree. The fact that an index is at a new high does not necessarily imply euphoria using this approach. The risk premium is an objective measure which also worked well in 2000.
Using Data on Forward Earnings
Here is a good question. What would happen to the market if forward earnings declined by as much as they did in any year-over-year period since 1979 and the market got a small P/E bump to 15.5. (That's when the First Call series starts).
The answer: A decline of 14.4%. The biggest forward earnings decline (almost 18%) came in the year ending with November of 2001. If forward earnings now fell by that amount and the P/E moved to 16 (still a very high risk premium), the S&P would be down less than 12%. It is difficult for the market to crash when so much risk is built in.
The time period includes both the 1987 crash and the 2000 bubble, so it is quite relevant.
The market, despite new highs, reflects a lot of skepticism. It is ironic that the many pundits predicting recession and a market decline believe that they have had no impact. In any market there is a chance of decline. Meanwhile, any reduction in worries could lead to a much higher P/E multiple.
It is all about risk versus reward. To analyze this, the investor must know what is already built into the market, not just a black-and-white doomsday scenario.
For traders, this analysis shows why there is a continuing bid under the market, even in corrections. Active traders who have recognized this have profited in the last month.