As we start a new year, the universal view of market pundits is that bonds suck wind and stocks look okay. This alone should make equity investors nervous and give some comfort to bondholders. But expectations are modest: the S&P 500 closed 2013 at 1848 and 2014 year-end targets from various investment banks range from 1850 to 2000, corresponding with returns of 0% to 8%.
As we know from (sometimes bitter) experience–and extensive research–such predictions aren’t worth the paper they’re printed on, but can we say anything useful about risk?
According to Sentiment Trader, which monitors investor sentiment, several stock indicators are flashing red. For example, newsletter optimism is at a record high–always a contrarian indicator; in addition, individuals exposure to stocks is at its highest since 2007; finally, the ratio of stock returns to bond returns is three standard deviations from its historical average, which is also a warning sign of excessive stock market ebullience.
On the valuation front, analysts have noted that the rise in stock prices has been driven primarily by multiple expansion rather than by rising corporate profits. As a result, the Shiller price-earnings ratio (the cyclically-adjusted P/E or CAPE) stands at 25, well above its historical average. Based on a similar metric, Cambridge Associates reckons U.S. equities are about 30% (or one standard deviation) overvalued, which is high but not extreme.
So are stocks primed for a crash? No. Like everyone else, I have no idea what stocks will do in the next one, three, six or twelve months. But the valuation and sentiment data do suggest that stocks are vulnerable to any diminution of the economic optimism that has underwritten their surge. In other words, good news is already in the price, leaving little room for any disappointments that might show up.
The opposite applies to Treasury bonds. Although by no means undervalued, they’re certainly unloved. If the economy were to slow down unexpectedly, Treasuries would benefit while lower-rated credit would get whammed.
So don’t reach for yield and don’t allow your stock market exposure to exceed your target allocation just because the market has soared.