The nine-year stretch of rising stock prices won’t last forever. So now’s a good time for investors to bear-proof their 401(k)s before the next financial storm. USA TODAY
Guarding against irrational exuberance is critical right now.
That’s because the stock market’s strong recovery from its early February drop has fooled investors into thinking the bull market is invincible.
It’s true the bounce-back has pushed several market averages to new all-time highs, notably the NASDAQ Composite and the Russell 2000 index. To be sure, the large-cap dominated Standard & Poor’s 500 is not back to its January high, even though it has recovered nearly half of its losses from the early-year “correction,” or drop of 10%.
This revival has encouraged investors to take on too much risk. They will regret it the next time the market declines. And, sooner or late, it inevitably declines.
Irrational exuberance, a phrase that has come to mean out-of-control prices for stocks, is on full display when you look carefully around Wall Street.
Consider the Russell 2000 index, perhaps the most widely-used benchmark for shares of the smallest companies. These typically are the fastest-growing and most dynamic names.
At first blush there appears to be no cause for alarm with these stocks. Why? Look at the price-earnings ratio, or P/E, which is the price of a stock divided by its earnings per share.
According to FTSE Russell, the organization that maintains the index, the collective P/E ratio for all the stocks in the Russell 2000 is just 22.6. Another organization — iShares, the division of Blackrock that offers the exchange-traded fund benchmarked to the Russell 2000 — reports an even lower P/E, at 20.8. Both ratios are below that of the large-cap dominated S&P 500, and since small-caps typically trade for higher P/Es than the large-caps, you would be excused for thinking that prices aren’t out of control.
Yet you would be wrong. According to Vincent Deluard, head of global macro strategy at INTL FCStone, a financial services firm, the Russell 2000’s current P/E ratio actually is 89.2. That’s four times higher than what FTSE Russell and iShares are reporting. Alarm bells should be going off everywhere.
The reason that the FTSE Russell and iShares ratios are so much lower: Their calculations exclude companies in the Russell 2000 index that are losing money, since a P/E ratio can’t be calculated for a company that has no earnings. This wouldn’t have much of an impact if it involved only a few companies, but, in fact, a third of the companies in the Russell 2000 currently are losing money. (For the record, I should stress that the websites of both FTSE Russell and iShares acknowledge that their calculations exclude these losing companies.)
Deluard corrected for this bias by totaling results for all 2,000 companies — both those turning a profit and those losing money. And taking losing companies into account is the correct thing to do, he argues, since excluding them is the “functional equivalent of reporting profits before expenses.”
Two important investment lessons to draw: Always understand what’s behind a number (in this case, what’s NOT included), and it’s more important than ever to get to the bottom of things when euphoria is sweeping Wall Street.
This discussion raises a broader — and perhaps even more profound — investment implication: a decreasing percentage of publicly-traded companies are profitable.
Consider the proportion of publicly-traded corporations’ total income that comes from the top 100 firms.
This percentage was 48.5% in 1975, according to research conducted by finance professors Kathleen Kahle of the University of Arizona and René Stulz of Ohio State, and only slightly higher in 1995 at 52.8%. Since then it has mushroomed, and by 2015 it stood at an astounding 84.2%.
Some even claim that we are moving to a “winner take all” world in which only a few companies make almost all the profits, and everyone else is left to scramble for the few crumbs. If so, it means the market averages are a lot more vulnerable than ever before to earnings missteps by a few winners. We got a perfect illustration of that vulnerability this week, when Facebook’s 7% plunge caused the Dow to plunge more than 300 points.
To be sure, this shift toward a winner-take-all economy has taken place over many years, and the market, in the long-term, has moved higher. And it no doubt could continue to rise even longer. The Internet bubble continued inflating for more than three years after then-Fed chairman Alan Greenspan publicly worried about “irrational exuberance.” Yet, when the bubble did eventually burst, few complained that his warnings were so early.
Don’t let that lesson be lost on you today.
Mark Hulbert, founder of the Hulbert Financial Digest, has been tracking investment advisers’ performances for four decades. For more information, email him at firstname.lastname@example.org or go to www.hulbertratings.com.
The views and opinions expressed in this column are the author’s and do not necessarily reflect those of USA TODAY.
So what’s a bull market anyway? It’s when the stock market rises 20 percent from a prior low. Despite some recent scares in the market, Wall Street will celebrate the bull market’s ninth birthday Friday. Josmar Taveras
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