S&P 500 has hit new highs. Is it time to sell stocks?
The three most common questions these days about the stock market:
- Stephen, would you sell stocks now? Looking at historic valuations the answer is a resounding ‘Yes’ it is time to sell the market as a whole but there is still pockets of value out there.
- Stephen, would you ‘short’ the market now? The answer is ‘No’. It is a little like trying to row a boat against the tide …………….. a struggle. This market loves Trump and what he wants to do. So for now, this is the trend and the market likes it. It’s hard to bet against it this momentum.
- Stephen, would you buy the S&P 500 index now? The answer is ‘No’. I would find value in individual sectors. Certain pharmaceutical companies are offering good value and paying good dividends. Abbvie, Glaxo and Novartis are on my radar. Also like Cannon and Total.
As regards the overall market, we need to look at some of the basics…..
Estimating the 2107 future value of the S&P 500……………………..
The classic share price formula is as follows:
EPS (Earnings per share) * PE (Price to Earnings)
For 2017 the average estimate for earnings for the S&P 500 is $131.54. The historical average PE ratio is 17. If we plug this information into our formula we get a target price of:
$131.54 *17 = 2,236.
The current value of the S&P 500 is 2,381. By this calculation the market could actually fall by 6% between now and the end of the year!
But…..It’s not that simple to predict!
Whilst using historical norms is a good reference point, it does not give us an absolute answer. Remember, the stock market is a function of expected future profit growth. If investors expect future profits to be greater than normal, investors will buy stocks in anticipation of the future and the PE can go much higher than normal. Therefore, we must look at future profit growth forecasts before making a decision to sell stocks.
It is very obvious that the market believes in Trump’s policy of:
- Lower Taxes
- Less Regulation
- Increased Spending
Right now, average analyst estimates for 2018 earnings per share is at $147.20. This represents earnings growth of 11.9% from 2017 to 2018 (if the analysts are correct). This is why the market is trading at such lofty multiples of earnings right now.
Assuming, PE multiples revert to their norm in 2018, the target for the S&P 500 would be:
$147.20 * 17 = 2,502
This represents 5% growth from today (Mar 2017) to the end of 2018. Maybe it is not the right time to sell stocks? Let’s consider another asset class before we start to make some educated decisions…………….
A word on Bond Yields………………..
The 10 year US Government Bond is now paying 2.5%. Government Bonds are considered ‘Risk Free’ as the likelihood of the US government defaulting on their debt is zero (in theory).
Now, you can invest your money for 10 years by lending it to the US government and get 2.5% interest per annum. In two years time that is a return of 5% on your invested capital – RISK FREE.
That begs the question…… if PE multiples normalise and the target for the end of 2018 for the S&P 500 is only 5% higher from here, why would you take the risk of buying stocks? Maybe it is not the time to buy stocks but it doesn’t necessarily mean that it is time to sell stocks either.
This will depend on your outlook and your belief in how effective Trump will be.
The stock market is pricing in right now, higher than expected earnings growth as a result of Trumps policy shift. There is serious momentum behind this move in the market. I’m a value guy so I don’t buy into it. At the same time, I find it hard to short the S&P 500 with the momentum that is there.
For stock investors with existing portfolios, you must assess the value of the stocks in your portfolio. What do you think they will be worth 12 months from now and why? If you have overvalued stocks, it might be the right time to sell stocks. If you are unsure, at the very least apply some option protection strategies such as the ‘Collar’ strategy. This will allow you stay in the stock but also protect most of the existing profits that you have made.
For stock investors considering entering the market, I wouldn’t buy the broad market index. You need to look for value stocks. In my opinion the pharmaceutical sector is a good place to start. But make sure you do your homework.
For option traders, volatility sucks right now (Mar 2017). Trading indexes is very difficult as you will most likely have to resort to low probability trades. Instead, trade earnings volatility but give yourself plenty of leeway for trades to go wrong. High probability trades, trade small and trade often!
Hope that helps in some way:
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