Stocks have hit a string of new highs this year, producing gains many investors had not expected given the age of the bull market and uncertainty surrounding changes in Washington.
Mid-year is a good time to see if your portfolio is doing what you want. And, as hard as it seems, standard practice calls for trimming some winners and moving to some weaker investments like bonds.
“With the S&P 500 index trading at a current (price-to-earnings ratio) of around 26 times current earnings, and a historical average being 16 times current earnings, U.S. stocks are trading at elevated valuation levels,” says Daniel Lugasi, portfolio manager at VL Capital Management in Orlando, Florida. “Despite this, we have still been able to locate value in the market.”
[See: U.S. News & World Report’s 10 Top-Ranked ETFs.]
The Standard & Poor’s 500 index, the most widely used market benchmark, is up more than 8 percent since the start of the year, piling gain upon gain to the run-up that began in 2009. This year’s gain to date is not far behind the full-year gain of 9.54 percent for 2016, surprising many experts who thought the bull market was getting old and that the markets would slump if Donald Trump won the presidential election.
While gains are welcome, they do come with risks. The more investors pay for every dollar of corporate earnings, the riskier a stock becomes, and stocks would have to fall by roughly half to get back to the average P/E. Although this ratio has been higher at times, those peaks have often been followed by steep losses. The S&P 500 peaked at more than 1,500 late in 2007, with the P/E quickly soaring above 100. Then the index lost half its value in short order.
Today’s high P/E reflects optimism over Trump administration goals of cutting taxes and regulation, says Lance Jepsen, owner of the GuerillaStockTrading blog in Clovis, California.
“I know a lot of people say markets are overvalued right now, but I think the high P/E ratios are telling us that the market is expecting big things from the Trump administration,” he says. “The big danger is if the Trump administration can’t get tax reform or is blocked by courts on regulation rollbacks, like what happened recently with the EPA being blocked from rolling back Obama-era methane rule.”
Fidelity Investments says in a mid-year report that U.S. companies “may have difficulty expanding profit margins from elevated levels as they face a secular peak in globalization and a cyclical pick-up in wages.” Ultimately, stock prices are based on current and expected earnings, and earnings disappointments hurt stock prices.
Fidelity also notes that lower unemployment could lead to wage increases that would boost consumer spending and shore up stocks, but that it could also raise labor costs for businesses and spur inflation — two factors that could dampen earnings and undermine stock prices.
Still, many experts are optimistic. Nuveen Asset Management in Chicago sees plenty of good signs.
[See: 5 Automakers to Rev Up a Long-Term Investor’s Portfolio.]
“Although many investors are questioning equity valuations, we believe valuations can be sustained or climb further, as long as corporate profits and earnings rise,” Nuveen says in a statement. “And notwithstanding some recent economic weakness, we believe the global economy should continue to accelerate modestly, providing a tailwind for corporate earnings, profits and equity prices.”
Experts generally advise reallocating holdings from time to time to keep the mix of stocks, bonds and cash on target, and that would mean shifting some money from stocks to bonds if the stock portion has grown larger than planned. On the other hand, bonds grow riskier when the markets expect interest rates to rise, as they do now, because investors won’t pay as much for older bonds that don’t earn as much as new ones do.
So, should investors reallocate or not?
Since most investors use mutual funds and exchange-traded funds, Lugasi recommends zeroing in on the benchmarks suited to individual funds — a large-capitalization benchmark like the S&P 500 for big-company funds and a small-cap one like the Russell 2000 for small-company stocks, for instance. Fund companies and the data firm Morningstar report each fund’s corresponding benchmark, so it’s not hard to find the right yardstick.
It’s a red flag if your fund has not done as well as its benchmark.
“The key is to use a benchmark that fits the style of the investment portfolio, otherwise there is no basis for comparison,” Lugasi says.
But even if your fund has kept up with its benchmark, big gains could mean you have too much in that fund. Most experts say that if one asset class has drifted off of its target allocation by 5 or 10 percentage points, it’s probably time to cut back and put the proceeds into a class that is short of your target allocation. It’s not necessary to fuss with the holdings if they’re off target by small amounts, because an adjustment one day might have to be reversed the next as the market fluctuates.
[See: 10 All-American ETFs to Buy Now.]
While no one knows for sure how the markets will do, many analysts expect the U.S. economy to continue growing modestly, and think the Federal Reserve will follow through on its plans to slowly raise interest rates, but not too high.
“We would note that the modest growth we project is dependent upon a fairly stable trade and geopolitical environment under the Trump administration,” says Keefe, Bruyette & Woods, an investment banking firm in New York City.
But the firm adds that things could go awry: “The prospect of trade wars, materially higher inflation, and a myriad of other negative macroeconomic shocks are all risks until the administration’s policies are known and implemented.”
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Time for Your Half-Year Progress Report originally appeared on usnews.com
