Seeking Alpha

Be Very Afraid For Stocks Only If This Happens

Includes: SPHQ
by: Clif Droke
Clif Droke
Long only, momentum, newsletter provider, ETF investing

Investors (wrongly) fear a meltdown in the S&P 500 in early 2020.

The forward S&P price-earnings ratio and dividend yield are still bullish.

Only if the S&P's forward PE ratio exceeds 20, should investors be afraid.

The beginning of 2020 has already seen plenty of year-ahead forecasts among analysts and commentators, and many of them are pessimistic. After the stock market's stellar returns in 2019, it's only natural that investors would fear a sub-par performance for stocks in 2019. But, as I'll argue in this report, stocks can - and most likely will - post another winning year in 2020 as long as interest rates remain low and the forward PE ratio for the S&P 500 doesn't exceed its 18-year peak.

Several major indices, including the S&P 500 Index (SPX), were sitting at record highs in the first week of 2020. The sustained rally in the indices since October has caused many investors to become nervous, however. With the SPX in "nosebleed" territory right now, the narrative that many commentators are spinning is that a "bubble" or "melt-up" is underway, which will end in disaster in the coming weeks or months. One look at the linear rise in the SPX (below) provides an idea as to why so many investors fear the worst-case scenario for stocks.

S&P 500 IndexSource: BigCharts

A continued rise in the SPX at the rate of ascent which has prevailed since October would definitely be a concern. However, there are no compelling fundamental reasons right now to fear an imminent collapse. Based on some key metrics, in fact, the bull market in the S&P is still justified and unlikely to end anytime soon.

One of the most important metrics that investors should be watching right now is the forward price-earnings (PE) ratio for SPX. Wall Street economic Ed Yardeni recently stated that investors should fear a serious correction in the stock market only if the forward PE ratio exceeds 20, a level it hasn't exceeded since 2002. You may recall that this development confirmed that a bear market had begun at that time about 18 years ago. As of this writing, though, the S&P 500 traded at 18.3 times 12-month forward earnings and is still under that key level. See the graph below.

S&P 500 Forward Price-Earnings RatioSource: Yardeni Research

The only time in recent years the S&P 500 forward PE ratio even came close to reaching the 20.00 level was in early 2018. You'll recall that 2018 was a rough year for equities, although it should also be remembered that after a sharp pullback in the index early that year, the SPX rebounded strongly in the spring and summer months before ultimately collapsing in October.

This leads us to another timely observation as it pertains to the year-ahead outlook. It should be noted that the nearly 20% collapse which the SPX suffered in Q4 2018 was largely the result of rising interest rates. When interest rates are consistently increasing, as they were at that time, then investors have every reason to fear a lurking bear. When rates are low or falling, by contrast, no such fear is warranted. (Remember the old Wall Street adage about bull markets ending only when the Fed pulls away the proverbial punch bowl? It definitely applies here.)

The steady increase of the Fed's benchmark rate throughout 2018 led to a widespread liquidation of rate-sensitive securities, which in turn bled into the broad market by the fourth quarter of that year. The Fed's severe money-tightening policy of 2018 can be clearly seen in the following graph.

Effective Federal Funds RateSource: St. Louis Fed

The present interest rate environment, by contrast, is far more benevolent for equities. With the effective federal funds rate currently at 1.55%, investors have no incentive to be sellers since the fed funds rate is far below the prevailing level for stock yields. For instance, as of Jan. 6, the S&P 500 dividend yield was 1.76% (below). This compares quite favorably with the 1.55% fed funds rate.

S&P 500 Dividend Yield

Source: Multpl

Historically, when the gap between the S&P dividend yield and the fed funds rate narrows - as it did in 2018 - that's when investors should begin to worry about the stock market outlook. However, investors in the aggregate seem content right now to own stocks for income over bonds. The ultra-low fed funds rate will therefore prevent another repeat of the 2018 sell-off from happening anytime soon.

To summarize, as long as the S&P 500 forward price-earnings ratio doesn't exceed 20, investors won't have much to worry about in the way of a stock market correction. Moreover, with the S&P 500 dividend yield well above the fed funds rate, investors have no incentive to liquidate their equity holdings anytime soon. Only if the runaway rally in the SPX continues unabated for several more weeks without halting, thereby causing the forward PE ratio to exceed 20, would investors have a reason to be afraid. For now, a bullish intermediate-term stance towards stocks is still warranted.

On a strategic note, I'm currently long the Invesco S&P 500 Quality ETF (SPHQ), which is my preferred broad market tracking fund for short-term trading purposes. I've adjusted the stop-loss level in this position to slightly under the $36.15 level on an intraday basis.

Disclosure: I am/we are long SPHQ. 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.