Worst Week since January 2016 for US Stock Markets

The Dow Jones fell 4.1% in the past week making it the worst week since January 2016. Friday alone, the Dow Jones fell 2.54%, the S&P 500 was lower by 2.12%.

We believe several factors are contributing to the significant change in the market and the correction may not be over just yet:

• P/E ratio very high compared to historical data
• Weak dollar increasing inflation
• Strong wages growth potentially increasing inflation
• Increasing yields, e.g. 10-year treasury yield
• Change in Fed leadership. Powell might change path compared to Yellen.
• Highest employment, lowest unemployment in decades, putting more upward pressure on wages

We’ll look at the P/E ratios in this post.

For quite some time we have been concerned about the P/E ratios of the stocks that are at the top of our list of favorites. Even though the P/E ratio is one of the factors that influences the content and order of our list of favorites, we cannot help but observe that quite a few of them have P/E ratios higher than 15 with some even higher than 30. For example Coca-Cola has a P/E ratio of 43.67 as of market close Friday. To some degree the P/E ratio expresses whether a given stock is seen as a premium stock by the market. For example Coca Cola are a dividend aristocrat. That plus other factor may potentially warrant a high valuation.

However, long term the average EPS growth needs to be equal or bigger than the P/E ratio. For example if the EPS growth is let’s say 20% and the P/E ratio is 15, then the stock might be worth a closer look. Obviously, if the outlook suggests that EPS growth slows down, then P/E ratios need to go down as well.

US companies had a fantastic run since 2008, with a total return including dividends of between 1.31% (2016) and 32.43% (in 2013) per year based on the S&P 500. For the last 5 years this amounts to a compound annual growth rate (CAGR) of +15.79%. For the last 10 years the CAGR is +8.49%, which includes the year 2008, the year of the Global Financial Crisis (GFC), dragging down the CAGR with a value of -37.22%. The index grew another 21.83% in 2017 including dividends. This indicates that the increase in valuation has accelerated. The graph illustrates this as well. This is not sustainable.

The question is, though: When does it come to an end? Since nobody can look into the future, nobody knows. It’s just a matter of time when the markets have to adjust to what is happening in the real economy. At the moment, despite the 4.1% drop this past week, we believe the market is still overvalued.

What does this mean? We don’t try to get the timing right. Instead we look at the long term picture. The S&P CAGR is 8.49% for the past 10 years, 9.92% for the past 15 years and 7.19% for the past 20 years. And we use a set of rules for managing our positions that are independent of market swings. As long as we manage to beat our benchmarks, the ups and downs of a particular day, month or year don’t matter.

Happy investing!

Disclosure: We own shares in Coca Cola and have no intention to change our position within 48 hours of publication of this post.