The U.S. stock market, as measured by the SP 500 Index, is up 6.9% so far this year, following last year’s melt-up of 29.6%. Last year, reported earnings of the SP 500 were up 6%. Consequently, valuation measures, including Price/Earnings Ratios, were up 23% last year, which has led many to wonder about a long-awaited price “correction.” When is the price correction, due to the rise in valuation, going to happen and how large is the correction going to be?
Many investment pundits attempt to call the market. I have done so on occasion over the last number of years – but, I typically tend to call the direction of the market. I rarely attach a price target to how high or low the market may travel. I have learned over the years that I have little idea as to how high or low the market may move over various periods of time. Frankly, if someone claims they know exactly where the market is heading, that person is probably attempting to fool him/herself and you, as well.
That being said, my calls on market directional movement have, on balance, been reasonably accurate. Am I, and are other pundits, able to see around corners? Of course not. Most serious market analysts understand historical trends and the fact that the stock market reflects some very fundamental facts. Let me disclose some tricks of the trade that anyone can use to make a prediction as to where the stock market may be heading.
Direction vs. Level
We have found over the years that we can normally break down the drivers of stock index movement into four “buckets.” At my firm, Mariner Wealth Advisors, we call these buckets our Four Cornerstones. They are:
- Monetary policy. Is annualized M2 (money supply) growing more rapidly than nominal GDP? If so, monetary policy is probably “easy,” leading to higher asset values.
- Investor Investor sentiment. Are people overly bullish or bearish regarding their view of the markets? If so, the market may be heading in the opposite direction of prevailing sentiment.
- Valuation. Is the market over or under valued based on historical comparisons? While valuation in and of itself is a lousy market-timing tool, it is helpful in determining how much the market may move based on levels of over/under valuation.
- Earnings or Corporate Profits. Are earnings rising or falling? If they are rising, the stock market is probably going to move upward. If earnings are falling… well, you get the picture.
Which of these cornerstones has historically had a stronger prediction value regarding what direction stock prices may be heading? By far, the direction of earnings has proven to be the best predictor of stock index movement.
According to our friends at Ned Davis Research, since 1985 there has been a 91% positive correlation between stock index prices (rising or falling) and the direction of operating earnings changes (rising or falling). So, if you believe corporate profits are going to rise going forward, based on historical data, you have a 91% probability of being correct on your market direction call.
Another trick of the trade of market forecasting is the fact that stock prices, over a full year, tend to rise. Since the end of WWII, stocks have generated negative returns in 15 calendar years. Over a 68-year period, stock prices have risen 78% of the time – again, on a calendar-year basis.
It starts to make sense that:
- Unless we are heading for recession, corporate profits normally rise.
- Since the end of WWII, stock prices have risen 78% of the time.
Then, it starts to become reasonable to expect that stock prices should rise the vast majority of the time.
When a market pundit says stock prices should rise/fall, don’t be amazed. We market strategists know history.
So, where do I think stock prices are heading this year? I have been calling for stock prices to rise since the first of the year. I believe corporate earnings will continue to rise for the remainder of 2014 and into 2015, as we see little chance of a recession starting within the next six to nine months.