Even after this week’s pullback, the S&P 500 has gained more than 16% year-to-date. At the same time, corporate profits only increased about 3% year-over-year in the first quarter and are projected to increase by a mere 2% in the second quarter.
Revenue growth was even weaker than profit gains, as cost cutting has become the primary means of generating higher earnings. This combination has moved the S&P’s price-to-earnings (P/E) ratio to roughly 16, compared to a five-year average of 14.9. From our perspective, this means that valuations are moving towards the expensive side.
By some measures, such as the cyclically adjusted, longer-term average P/E ratio, the market looks even more expensive. When stocks are expensive, we are not aggressive buyers.
Yet by other measures, such as forward-looking P/E, the market looks to be trading around fair value.
Meanwhile, interest rates remain low, but they appear more likely than not to move higher, which would negatively affect bond prices. Given the weak outlook for bonds, stocks appear to be the more attractive option.
Against this backdrop, investors’ options are limited and the importance of valuation in the security selection process is even more important. In short, this is a stock pickers’ market, and this is what we do.