Don't Rush To Sell Stocks At These Levels

Includes: SPY
by: Ted Barac

A fellow contributor recently wrote that now was not the time to rush into buying stocks. Even if there was considerable stock appreciation from today, the article argued that a large bear-market correction (as in 2000 and 2008) could bring the market back, again, to below current levels. The article then went on to illustrate how much stock prices would need to appreciate (from here) in order to break-even, should a bear market of 40% occur.

To begin with, I would argue that 40% is not a good base-case scenario to use -- as there have only been three bear markets over the past 70 years of 40% or greater ('73, '00, and '08). Just because two of them happened to be in the last 12 years, I wouldn't assume that this is the new norm. One also needs to bear in mind what another decade or so of flat stock prices would entail.

From Q1 '00 (around the beginning of the '00 bear market) to Q2 2012, U.S. GDP increased by over 60%, in nominal terms, while the S&P 500 declined by 9% (also in nominal terms) over the same period. How long can such market underperformance (relative to GDP) last, with bear market corrections more than offsetting the interim gains? Bill Gross recently argued that real stocks returns cannot outpace real GDP growth indefinitely. While his argument seemed to ignore dividends (and thus, I believe, was flawed), he would have been right that stock PRICES probably cannot outperform GDP indefinitely. Similarly, however, I would argue that stock prices probably cannot underperform GDP indefinitely.

With respect to a potential bear market, the article's primary justifications for such a likelihood was that margin debt was at multi-year high levels, so there "is enough leverage built up to cause a decent size bear market whenever the time comes for institutional players to start selling." To illustrate this point, a chart was provided showing multi-year high margin levels at points before the market sell-offs of 2000 and 2008 (when the stock market levels were also at multi-year highs).

The problem, as I see it, with the author's argument is that margin debt is highly correlated with stock prices (as was, also, illustrated in the contributor's charts). Brokers lend based on the asset values of account holders, which are based on the prices of the securities in the accounts. So, yes, leverage is higher when the markets go up -- but so is the collateral (the securities backing the loans).

Therefore, as long as the higher security prices (and resultant collateral levels) are justified, the increased lending is not necessarily a problem. Leverage may be too high, relative to the collateral supporting the loans, but to argue such a claim, you need to show that the increased collateral valuations are unjustified, and not just say that leverage is too high because it's gone up a lot.

Furthermore, because of the correlation between margin loans and stock prices, saying that multi-year high margin levels may signal a forthcoming bear market is only as true as saying that multi-year high stock prices may signal the start of a bear market. Such a theory would have proven to be true in 2000 and 2008, but not in other historic periods. The S&P 500 (NYSEARCA:SPY) doubled from 102 in 1980 to over 200 in 1985 (and I imagine that margin levels increased substantially, over that period, as well). If you took that market doubling as a signal to sell, you would have missed out on the additional (over 7-fold more) increase over the next 15 years. Secular bull markets can last a long time.

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Going back to valuation and collateral, I believe that current equity valuations seem reasonable. With a forward P/E ratio of 13.75 for the S&P 500 (and an earnings yield of over 7%; relative to a 10 year Treasury yield of around 1.8%), I think it's hard to argue that stocks are overvalued, based on current earnings and valuations.

Furthermore, I think it's hard to say that earning are near a cyclical peak when we are only a few years into a recovery from a financial crisis of historic proportions and unemployment remains high. What's going to happen if the economy actually recovers (low unemployment), P/E multiples expand to historic norms, and earnings yields, relative to Treasury yields, compress to levels closer to the historic relationship?

All things considered, should we expect another decade of market stagnation or the beginning of another multi-decade bull market? The answer probably lies somewhere in between. While I am cautious of the potential for a short-term pullback, I remain bullish on equities (particularly, relative to other asset classes).

Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.