So far this year, stocks have exhibited significant volatility. We closed 2011 at 1,257 on the Standard & Poor’s 500, and currently stand at 1,390, representing a 10.6 percent gain year-to-date. But recent volatility and the pending U.S. elections may derail what has been strong performance for stockholders so far this year.
Despite the strong year-to-date performance noted above, investors have suffered through a lot of ups and downs this year. Although stocks provided a reasonably smooth, positive performance for the first four months of the year, May’s performance was dismal, with stocks shedding almost all of the year’s gains. The S&P 500 fell from a high in April of 1,422 to a low at the beginning of June of 1,266 — just nine points above 2011’s final level for this index. This drop represented an 11 percent decline for the S&P 500 and was sparked by renewed concerns over the European debt situation.
One can usually point to reasons why stocks sell off, but from my perspective the real reason it happens, especially when we experience significant percentage drops in short time intervals, is because valuations are too high. If stocks had not run up to the high of 1,422 from the year-end level of 1,257, valuations would not have been extended, and therefore, even with bad news from Europe, stocks would not have had as far to fall.
One can point to any asset class and see the same trading patterns over time. Take real estate, as a perfect, recent example. In the hottest markets, once the bubble burst, values were pummeled in those hot markets, including here locally, where prices have dropped well over 50 percent from the peak. But in other markets across the United States where prices did not skyrocket, real estate prices did not decline nearly as much, either as a percentage or in dollar terms.
My point is that investors need to be aware of valuations when making investment decisions. More to the point, with the recent rally for stocks — with the S&P 500 now approaching 1,400 again — valuations are once again extended. To add to the potential for declines, corporate earnings and growth in gross-domestic product have slowed considerably. Once valuations become extended, they can stay that way for long periods of time. However, a significant negative event can serve as the justification for investors to dump stocks when these conditions are present, causing substantial short-term stock market corrections (like we saw earlier this year in May).
With U.S. elections looming large on the near-term horizon, and stocks once again reaching recent highs, investors should pay close attention to these macro factors when deciding what to do with their stock holdings. There are many key issues that we face with regard to the political process, not the least of which are the Bush-era tax cuts that are set to expire at the end of this year. The outcome of the Nov. 6 elections will certainly play a key and determinant role in whether these cuts, or at least key parts of them, will be allowed to expire, or will be extended. Income tax brackets, capital gains and dividend tax rates, and even the tax benefits of interest on mortgages, will be among those items directly affected by this election.
Stocks will certainly react to the outcomes of elections, as investors weigh the relative importance and impact of each candidate, from the president on down. Markets trade on expectations for the future, so as investors evaluate the possible implications of the election outcomes, stocks will be bought or sold and markets will move. Intelligent investors will not make investment decisions based solely on the merits of individual investments, but rather will weigh the fundamentals of investments in the context of the economic and political landscape. A significant aspect of that analysis must also be broad-based market measures, such as stock valuations relative to expected future growth for earnings.
As the elections draw near, and if stocks continue to rally above the 1,400 level on the S&P 500, I will look to reduce exposure to stocks for my clients. While a positive outcome from elections (from a stock market perspective) could drive stocks even higher, extended valuations pose a significant risk to stocks at present. I have always believed in using cash as an asset class that is at least as important as any other. I frequently raise cash whenever I am uncomfortable with valuations, or with the risk in the market for whatever reason. This approach has served me well over the 23 years I have been managing assets for clients.
My advice is to understand the investing environment and to evaluate all investments in the context of that environment, and to not be afraid to raise cash and wait. Sometimes being patient and conservative can not only allow investors to avoid major declines, but can also offer compelling opportunities to reinvest cash after major corrections.