Weighing the risks in the market cycle

Matthew F. Beaudry

Matthew F. Beaudry
Senior Investment Director , 5/5/2016


At this point of the market cycle — nearly seven years after the last bear market, and with uncomfortable memories of two corrections during the past year — positive and negative forces have struck a near balance.

Looking at the positives

Fortunately, China’s prospects have seemingly improved from the beginning of 2016, as the world’s second-largest economy has a better economic and growth outlook and generates less fear about the devaluation of its currency, the yuan. Meanwhile, in the United States, the dovish Fed has taken a stance more in sync with the markets, the U.S. dollar has weakened, and commodity prices have rebounded. Better U.S. manufacturing data, in particular, along with continued employment gains, as well as prospects for better earnings and the end of the profit recession, are also positive for the markets.

A meaningful reversal in any one of the current positive trends is possible and ramifications could be swift.

Estimating different scenarios

At the same time, there are some liabilities on the ledger. A meaningful reversal in any one of the current positive trends is possible and ramifications could be swift. However, as such reversals are unlikely in the near term, a more pertinent risk to address is assigning the correct price-earnings (P/E) multiple for the market given the environment of near-zero interest rates. While it is difficult to assign an exact figure, professional investor consensus has established a range of 15x to 18x earnings. Applying those numbers to 2016 earnings estimates of approximately $120 for stocks in the S&P 500 Index, establishes a range of 1800 to 2160. Investors may be hesitant to commit new capital to equities when the S&P is near the upper end of this range. Until a clear economic trend emerges in either direction, or earnings growth accelerates dramatically, it is likely that stocks will continue to trade in this range for the foreseeable future.

One last significant bearish risk to consider is the “perfect storm” scenario, in which an inflation spike or rapid acceleration in global growth would cause the Fed to start raising rates aggressively at the moment when economic data begins to roll over. While this scenario should be considered, there is little data to suggest that such a situation is imminent.

Weighing everything together

The bottom line is that stocks appear poised to deliver mid-single-digit earnings growth with an economic backdrop of 2%–2.5% real GDP growth, 1.5%–2.0% inflation, and continued corporate share buybacks. Earnings would tell most of the story. An expansion in P/E multiples would be unlikely at this stage of the cycle, and dividend yields are around 2%. In short, the most probable scenarios suggest that decent but muted returns from stocks can be expected.

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