Barron's: As Stocks Near Their Highs, Resist the Call of These Safe Heavens

Published April, 2019

By Jack Hough

The U.S. stock market is approaching an all-time high. Relative to earnings, it is pricier than average. And in the next few weeks, we’ll learn whether first-quarter earnings have merely stalled versus a year ago, or gone into decline.

Facts like those sound as if they ought to be delivered on a sympathy card strapped to a therapy goat.

It may not be a surprise, then, that nervous investors have been pouring money into low-volatility stock funds. These supposedly dampen market upside by a little and downside by a lot, resulting in added safety and extra long-term return. But the approach is looking crowded and unnecessary.

When people warn about market highs, nod thoughtfully while ignoring them. Most prices rise over time. Whiskey, say, is close to a new peak, but that’s just inflation. Stocks do even better than inflation because they represent businesses whose workers, unlike bottles of booze, actively create value. If stock returns were linear rather than squiggly, every day would bring fresh highs.

More worrisome is when stock prices get stretched relative to fundamental measures of value, like earnings. The S&P 500 index trades at 18 times last year’s earnings, based on a dressed-up measure of earnings that ignores some nonrecurring costs. Historically, the average is about 15 times naked earnings.

Still, elevated prices don’t rule out more gains. The S&P 500 was this expensive at the end of 2016. It has returned 36% since. The 10-year Treasury recently yielded 2.6%, only a 10th of a percentage point more than in late 2016. For stocks, least ugly is still as good as handsome.

And we may dodge an earnings recession. The latest consensus has first-quarter earnings declining 3.8%, which factors in the 15% of companies that have already reported, but not the tendency of companies to bust through carefully weakened estimates Kool-Aid-Man-style.

An earnings recession is two or more consecutive quarters of falling earnings, according to the Department of Arbitrary and Unsourced Financial Definitions. But not even DAUFD knows whether second-quarter earnings estimates, now about flat versus a year ago, will continue their gentle decline, or stabilize.

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