By James Calhoun, Accuvest
While macro-economic trends point to a continuation of strength in US equities, macro-economic levels point to elevated risk. A late cycle reduction in equity risk for portfolios must be balanced against the opportunity cost of better-than-average returns.
The final year of a bull market is often uncomfortably profitable, as the S&P 500 averages a return of 15% in these years. Above average returns reveal the higher risk at this stage of the cycle. This high return vs. high risk reality compounds the importance of accurately managing equity risk late in the market cycle.
To achieve this objective we explore the lessons of history. While not perfect, the coexistence of high cyclically adjusted valuations, low unemployment, strong economic growth, and high inflation has historically been a precursor for negative equity returns (i.e. the prerequisite for a big fall is a long climb). As reviewed below, these precursors are in place and extended from the mean.
Currently, the S&P500 cyclically adjusted price to earnings ratio is 27.8x. From a levels perspective, this equates to the 83th percentile relative to the last 20 years (relatively high). From a trend perspective, this valuation measure has increased, or expanded, 2.8 points over the last 6 months. (see chart 1)
Chart 1: S&P500 Cyclically Adjusted Price to Earnings Ratio
Likewise, the current ISM Manufacturing Index level is 59.1 (any readings above 50 suggests economic expansion, below 50 suggests economic contraction). This level equates to the 95th percentile relative to the last 20 years. The trend in ISM Manufacturing is also positive, increasing 2.6 points over the last 6 months. (see chart 2)
Chart 2: US ISM Manufacturing PMI