Investors have reaped the benefits of a market recovery since March 2009. The SPDR S&P 500 Trust ETF (NYSEARCA:SPY) is now trading significantly higher than the market peaks from 2000 and 2007. The S&P 500 is now trading with a trailing PE of 18.6 and a forward PE of 17.3 according to the SPY webpage. The trailing PE is higher than the historical average PE of 15.5. However, the market's PE is not at such lofty levels that would indicate irrational investing. The market seems to be following a natural multiple expansion as the economy improves and earnings increase.
Of course, the economy's growth has been stimulated by the low interest rate environment. If the U.S. economic growth continues to improve at a slow, but steady pace, the longer the Fed is likely to postpone raising interest rates. Right now, we have lower oil and gasoline prices, so inflation is likely to remain low enough not to warrant an interest rate increase. Historically, the Federal Reserve begins to raise rates when the annual GDP growth rate hits 3%. This is expected to happen in 2015. However, if we don't see a significant rise in wages and consumer prices, the Fed is likely to postpone raising rates in my opinion. This may prolong the economic expansion and the bull market in stocks.
Since the market's current valuation level has surpassed the historical average, we probably won't see annual gains as large as what we experienced for the past few years. We are not likely to see annual gains of over 20% or 30% in 2015 and beyond. With the market's multiple a few points above the historical average, annual gains of approximately 10% would be more reasonable. There is still room for multiple expansion in the market if the U.S. economy continues to post gains as measured by annual GDP growth and the revenue/earnings growth of individual companies.
The market's PE ratio by itself is not a great indicator of how the market will perform going forward. For example, the PE ratio was 19.4 at the peak in 2007, while the PE ratio was 27 at the bottom in 2002 and 116 near the bottom in 2009. So, the market's direction has more to do with health of the economy. We can expect modest sell-offs in the market of 5% for profit taking throughout the year. Corrections of 10% would most likely be the result of some significant negative news that would affect a large portion of the world's economy or an event that would trigger significant fear in the markets. Some examples could be significantly worse than expected economic news from China, a large-scale terrorist attack, something similar to the European debt crisis, or a large unexpected event that could have negative economic implications.
Since the U.S. economy is showing steady increases as measured by annual GDP growth, the market is likely to end 2015 higher than it is right now. That is, if annual GDP growth hits the estimate of over 3% next year. We can expect sell-offs in the market along the way, but the overall direction of the market should continue upwards as the economy continues to show increases.
Recessions are usually preceded by a series of interest rate increases and an inverted yield curve. The Federal Reserve is likely to begin raising rates to curb inflation. However, with oil and gasoline at lower than normal levels, prices of many other goods may not increase as transportation and other costs are lower. Historically, the Fed begins raising rates when the annual GDP growth hits 3%, which could happen in 2015. However, if wages and prices don't rise, it is possible that the Fed would postpone raising rates. I would think that if we do get 3% annual GDP growth in 2015, wages, oil, and other prices would also rise. If the Fed does begin raising rates next year, it won't indicate an end of the economic growth - it just may slow the rate of growth going forward.
The next recession would probably come after a few years of rate increases. Another early warning sign for a recession is when the yield curve becomes inverted (when short-term interest rates exceed long-term interest rates). For example, if the 3-year Treasury yield was higher than the 10-year Treasury yield, the yield curve would be inverted. Recessions tend to occur a few months to a year after the yield curve becomes inverted. This is not likely to happen in 2015. It may take a few years for this situation to occur.
All told, the market is likely to gain approximately 10% in 2015, which would be more in-line with corporate earnings growth. This also seems reasonable based on the current market valuation and where we are in the economic cycle. This would place the price of the S&P 500 at about $2200 - $2300 and the Dow Jones Industrial Average at about $19,500 - $19,800 by the end of 2015.
How to Invest in Any Market Environment
Perhaps you don't believe my assessment of the market. Or, you think that a large correction is on horizon. Ultimately, anything can happen in the short-term. It is the unexpected events that throw everyone off guard. For this reason, I have always been a strong advocator of dollar-cost averaging as an investing strategy. Sure, investing in individual stocks is more exciting and can be done with smaller quantities of money. However, to effectively grow wealth over the long-term and to mitigate overall risk, I am a proponent of dollar-cost averaging. It is a proven strategy that grows wealth over the long-term. By investing a set amount of money at equal intervals (ie. monthly, quarterly), investors are buying at bargain prices when the market is declining and they benefit from price appreciation when the market is rising. This strategy also takes emotion and the guesswork of trying to time the market out of the equation.
Investing in the SPDR S&P 500 ETF on a regular basis is one way to accomplish this to gain the benefit of dollar-cost averaging. Your money is being invested in a large quantity of companies, which reduces the risk of owning individual stocks. Another alternative is to dollar-cost average into the Vanguard Total Stock Market Index ETF (NYSEARCA:VTI). Vanguard funds have very low expense ratios, keeping investor's costs to a minimum. This particular ETF has an expense ratio of only 0.05% which is even lower than SPY's expense ratio of 0.09%. By purchasing a diverse ETF on a regular basis at set intervals, investors don't have to worry about market fluctuations, provided that they have many years to go until retirement or until the money is needed. By being disciplined in this manner, investors can build wealth over the long-term.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.