The S&P 500 Index just posted its best calendar year since 1997. Upon mention of that fact over the last few weeks, most of the investors I talk to become quite concerned, which is not surprising. After all, anyone who has been an equity investor for 15-plus years remembers the investment environment in the late 1990s. While the stock market produced stellar gains for five consecutive years (20%+ annual gains from 1995 to 1999), the overvaluation that resulted in the technology and telecom sectors led the S&P 500 into a near three-year bear market that resulted in a 49% decline in the index.
While you might instinctively shudder at the thought of equity returns similar to those in the late 1990s, it is important look beyond performance to understand how today’s market environment compares to that time.
By the late 1990s, stock valuations had reached unprecedented levels, even surpassing the levels that preceded the Stock Market Crash of 1929 that triggered the Great Depression. This was largely due to investors’ infatuation with technology and telecom stocks, which drove stock valuations in those two sectors well beyond rational levels. Because of the significant appreciation of the stocks in these two sectors and the market-cap weighting methodology of the S&P 500 Index, their combined weights in the index rose to nearly 42% by the end of the 1990s. (Comparatively, their combined weights are half of that now.) The end result was that extremely overvalued conditions in only two of the stock market’s ten sectors resulted in the stock market itself becoming historically overvalued, which ultimately led to the bear market when the prices of tech and telecom stocks crashed.
Today, equity valuations within the U.S. are not yet at alarming levels—though they are not at attractive levels either. Valuation is an extremely important determinant of long-term returns, but it fails as a reliable short-term indicator as overvalued conditions can last for years. The S&P 500 is at a similar valuation level now as it was in 1996. Had you exited stocks at that time due to valuation concerns, you would have missed another three-plus years of significant returns. This is why we feel comfortable maintaining U.S. stock exposure despite elevated valuations levels as long as the momentum remains strong.
Aside from small slivers of the market like social media stocks, we do not see any areas of extreme overvaluation within the U.S. market that could potentially drag it down. Additionally, stocks outside the United States remain relatively cheap. As a result, we continue to maintain significant exposure to European and Japanese equities, which offer a sanctuary for value-conscious investors should U.S. stock valuations climb even higher.
While bear markets typically begin with overvalued conditions, the fact that valuation is a weak short-term indicator of future market performance leads us to incorporate other variables in trying to predict the likelihood of an impending bear market. One of those other variables is monetary policy as bear markets tend to occur as or after the Federal Reserve is removing liquidity from the economy via tighter monetary policy. This was the case in the late 1990s as the Fed began tightening monetary policy in 1999 by increasing the federal funds rate from 4.75% to 6.50% over a 12-month period. While overvalued technology and telecom stocks ultimately would have crashed on their own, this removal of liquidity from the market in such a short period of time was certainly one of the catalysts that caused the crash to begin in 2000.
Today, monetary policy remains historically accommodative with the target fed funds rate set in between the range of 0% to 0.25%. While the Fed has announced a tapering of its purchase of longer-term bonds, they have been utterly clear that their target fed funds rate will remain in place until the unemployment rate falls to at least 6.5%. Given the rate of recent job growth, that is unlikely to occur in 2014, so you can expect at least another year before the Fed begins to tighten monetary policy.
Mutual Fund Flows
Despite the S&P 500 Index producing its fifth consecutive up year in 2013, this current bull market has progressed without a meaningful segment of the investment public participating. According to the Investment Company Institute, equity mutual funds had positive inflows in 2013 for the first time since 2007, the final year of the last bull market. After losing significantly in last bear market, many investors simply gave up on stocks and are only starting to come back now. The 1990s were a much different environment as equity fund flows were positive for each year in the decade, ultimately peaking at a record high in 2000, just as the market was beginning to falter.
While 2013’s stock market performance resembled that of a year from the late 1990s, there is little else of note comparable between then and now. Therefore, you should temper your expectations for a multiple-year run of 20% returns as well as your fears for a significant decline in stock prices.