UPDATE: 'Tis the Season for Volatility

by Matt Malick and Ben Atwater In 2010, 2011 and 2012 the spring has proven to be a tough time for stocks.  The old market adage “sell in May and go away” may seem like a no-brainer, but it is impossible to time the market over the short-term.  So with volatility creeping back into stocks, we think it continues to be advantageous to take a long-term perspective.  After all, the 16% drop in 2010, the 19.4% drop in 2011 and the 9.9% drop in 2012 were simply pauses in a powerful bull market that began in March of 2009. The two charts below are encouraging signs that equities may continue to have legs. The vast majority of investors are highly skeptical of the new highs in the Standard and Poor’s 500, but one must examine these highs in context.  Below you will see the 2000 high, the 2007 high and the recent 2013 high.  Presently, equities have much more earnings power than they did at the previous two peaks, while they trade at roughly the same price.  In other words, the market seems to be more fairly valued now.  Furthermore, we have some catching-up to do.  Between 2000 and 2013, S&P 500 earnings grew at an average annual rate of 5%, while the market was largely flat.  Over the long-term, earnings growth and market growth are highly correlated. Next you will see estimated future returns using a cyclically adjusted price-to-earnings ratio for the market.  In other words, the price-to-earnings ratio (a standard measure of how “expensive” stocks are) is adjusted for inflation and then averaged over the previous decade.  This is a conservative measure of valuation.  By this measure, stocks aren’t expensive, nor are they cheap.  Rather, they are in the 3rd quintile.  Using historical market data from 1926-2013, when stocks have been priced at this level, they have averaged a forward five-year return of 6% per year.  Although not robust, in today’s low interest rate environment, most investors would be pleased with this rate of return.   www.atwatermalick.com