As the new portfolio manager at Colorado Capital Management, one of my priorities is to keep you informed of our latest thinking about the economy, the market, and our investment strategy. When there are significant noteworthy events that occur between our quarterly newsletters, we plan to send out emails and blog posts to you with our perspective on these developments. We will be referring to this new series of communications as The Bottom Line.
Today we’d like to give some attention to how the U.S. economy and U.S. stock market have recently been moving in different directions. Earlier this month we saw the Dow Jones Industrial Average flirt with 17,000 and the S&P 500 post repeated new highs. This comes despite the economy contracting by 1% during the first quarter, and corporate profits dropping by 3% during this same period. Signs of economic growth and an improved employment picture, combined with lower interest rates from the European Central Bank fueled much of the recent bullishness in the stock market. Last week, however, investors retreated and stocks fell in response to lower global growth forecasts from the World Bank, disappointing retail sales data, upcoming changes in leadership within the U.S. House of Representatives, and the turmoil in Iraq with its resulting spike in oil prices.
The bottom line: The S&P 500 index of major U.S. stocks has risen close to 40% since the end of 2012. During roughly the same period (12/31/12 to 3/31/14), corporate profits are up only about 5%. This disconnect cannot continue indefinitely. When stock prices grow faster than underlying earnings, the price/earnings ratio of the stock market rises. This ratio for the S&P 500 is now at about 19, versus a historical norm of 15.5. This means that large U.S. stocks today are trading at about a 20-25% higher price than average. Using this same methodology, small and mid-size stocks are even more expensive. Certain conditions such as low interest rates and a positive growth outlook justify higher than average price/earnings ratios, but only to a point.
We are closely following the various factors contributing to the above situation. We are particularly concerned about U.S. corporate earnings growth, the quality of jobs that are boosting the recent employment reports (as well as the percent of people who have stopped looking for jobs), the inflation and interest rate outlook, global developments, and the nature of stock market inflows.
We are also reviewing our asset class targets and evaluating the positioning of our model portfolios. Additionally, we are employing a disciplined rebalancing process to bring client accounts closer to their asset class targets. From a client perspective, it is essential, now more than ever, to ensure that your specific asset class target matches your goals, time frame, and risk tolerance. If you have questions about your investment portfolio make sure you ask your investment advisor.
The Bottom Line also goes out by email. If you would like to receive an email newsletter of these communications please email us so we can include you on the list! We hope you find this initiative beneficial and welcome any feedback you may have.
Colleen Harvey, CFA
The information contained in this blog is general in nature and is intended for informational purposes only. Furthermore, this information should not be construed as a buy or sell recommendation. All expressed opinions are subject to change without notice. Because the facts and circumstances surrounding each investor’s situation differ, you should consult your financial advisor before taking any action based on this information.