Over the past nine years, we’ve been in our longest bull market in history, with annualized S&P 500 Index returns from Mar. 9, 2009 through the end of December 2018, coming in around 16.5 percent. And then the financial markets returned to their volatile ways. Since the high on Sept. 20, 2018, the S&P 500 has lost around 14 percent to end the year down around 4 percent.
I believe this speaks volumes as to why investors should have a well-diversified portfolio. Forecasting is a nearly impossible task as at this time last year, we thought 2018 would end with a moderate gain — until September, it looked like another stellar year for the markets. While I don’t focus too heavily on predictions, I do have some opinions as to what 2019 may bring.
As an adviser, I look closely at valuations. Valuations have clearly declined when measured by Price-to-Earnings ratio (P/E) of the S&P 500, which were at 17.1 as of Dec. 31, 2018 versus the long-term average of 16.55. This may seem as though market valuations are attractive and that investors should be buying. However, we have been in a historically low interest rate environment since 2008. This allowed corporations to borrow money and buy back their stock; therefore, allowing corporations to show gains in earnings per share when the reality is their share count is the only thing that has changed substantially.
This financial engineering has the effect of making a company’s P/E look more reasonable relative to long-term averages as both price and earnings are measured on a per share basis, and the number of shares is lowered by these changes. When you look at other ratios, the true story comes into focus a bit better. When looking at Price-to-Earnings Before Interest, Tax, Depreciation, and Amortization (P/EBITDA), a pseudo-cash flow measure, the S&P 500 looks to be overvalued by 27.5 percent. When you look at Price-to-Sales (P/S) another measure, which is difficult to engineer, the S&P 500 looks similarly overpriced by 26.9 percent.
Looking ahead, current P/Es would indicate we’re in for a good year while Price-to-EBITDA and Price-to-Sales lean toward another down market in 2019. The reality is while no one likes watching their investments fall, most investors understand that they cannot expect 10 percent returns every year.
We are nearly 10 years from the Great Recession. It would not surprise me to see more volatility in the financial markets in the short-term. You’ve seen me write many times that I believe an investor’s focus should be on the financial and economic fundamentals. Currently, inflation is slightly above the Fed’s target of 2 percent, gross domestic product growth recently measured at 3.5 percent, and both the employment situation and consumer sentiment remain strong. Unfortunately, when economic fundamentals are this strong, there is often not much room for improvement. However, equities tend to outperform inflation by a wider margin even when times are tough, which should allow investors to expand their wealth.
With a market like this, I believe your best course of action is to maintain your long-term strategic asset mix. If you need to update your financial plan or rebalance to put aside assets you know you will need within the next 10 years, now is a great time to do so.