The rally in U.S. equities this year to date has been nothing short of amazing. Against a backdrop of dubious economic fundamentals and fueled by highly accommodative monetary policy, the S&P 500 climbed 23.43 percent through Friday, closing that day at a multiyear high of 1,805.09.
The Dow Jones Industrial Average — a slightly more suspect but still relevant metric of overall market performance — closed the same day at 16,035.84, up 19.44 percent YTD and down just slightly from record highs hit at the end of November. Powered by particularly strong years for many of its component companies, the tech-heavy Nasdaq soared 30.53 percent through Friday.
It’s common at this point to expect one of two things to happen: Either the rally will lose steam and equities will stumble through a lackluster 2014, or those who cry “bubble” will be vindicated and there will be a correction.
Fears of the latter abound, and for good reason. The current Shiller price-to-earnings ratio — a PE measure that attempts to smooth out volatility — is elevated and has climbed pretty much nonstop since the beginning of 2013. The current Shiller PE of 25.47 compares against the long-term mean of 16.5 and median of 14.9. The ratio touched a high of about 27.5 in 2007 before equities crashed in the wake of the financial crisis.
The forward 12-month PE of the S&P 500 is also increasingly elevated. The index is trading at a forward PE of about 15, above its five- and 10-year averages but still below its 15-year average. This metric has also trended nowhere but up over the past year.
The likely catalyst of a market correction is a tapering of asset purchases by the U.S. Federal Reserve. America’s central bank has been purchasing agency mortgage-backed securities and long-term Treasuries at a rate of $85 billion per month for nearly a year. This unconventional strategy has driven down longer-term interest rates and artificially increased equity valuations. Curbing and eventually ending these asset purchases will put downward pressure on equity valuations that could overpower even strong business performance.
Minus a monetary, fiscal, or psychological shock, history suggests that 2014 will be a year of modest gains. Estimates vary, but historical data indicate that the S&P 500 index averages gains between 6.5 and 12 percent following years in which it climbs between 20 and 30 percent.
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