When the market hits new highs, it’s a sure-fire bet that cautious investors and contrarians will find reasons for pessimism. Such is the case now, with the Dow Jones Industrial Average (DJIA)'s recent record close at 20,100. Two key indicators suggest stocks face a growing risk of declines during Donald Trump's inaugural year as president, according to the Wall Street Journal.
Dividend yields and price-earnings (P/E) ratios are two closely watched indicators of valuations and the markets' direction. One warning sign is that soaring stock prices have pushed dividend yields near historic lows, with the Dow yielding about 2.5% and the S&P 500 Index (SPX) roughly 2%. That's according to data from the CFA Institute Research Foundation, as cited by Wall Street Journal columnist Jason Zweig on January 25.
Another red flag is inflation-adjusted multiyear profits. When these are used to calculate the market’s P/E ratio, the current value is 29, well above its long run average of 16, again per the CFA Institute.
Both indicators suggest diminished stock market returns going forward, Zweig writes in the Journal, though he cautions that these are imprecise predictive tools.
Economic Outlook Unchanged
Meanwhile, though the stock market has surged since Election Day, consensus forecasts of U.S. economic output over the next two years have been largely unchanged, according to another January 25 article in the Wall Street Journal. Additionally, the long-term potential growth rate of the U.S. economy is an anemic 1.8%, per the Congressional Budget Office (CBO) as cited by the Journal. By contrast, when the Dow hit previous major milestones (5,000 in 1995, 10,000 in 1999 and 15,000 in 2013), the potential growth rate was between 2.2% and 2.5%.
Investors may be betting that stimulative measures promised by the Trump administration will have more impact than professional economists are anticipating.
An increasing appetite for risk among investors is another factor contributing to the market’s recent rise, the latter Journal article observes. This is one explanation for stocks’ continuing advance in the face of historically high valuations and rising interest rates on bonds. Survey results released on Wednesday reveal that investors are expecting stocks to deliver returns that are 5.7 percentage points better than bonds, the Journal reports. Another explanation is that the Federal Reserve’s current plan for three rate hikes in 2017 signals confidence by the central bank that the economy is on a strong footing, with less downside potential.
Even with that optimism, after rising from 1982 to 2000, the market saw two epic crashes between 2000 and 2009, Zweig reminds investors. There's no guarantee that will happen again, but the Dow's lofty heights amount, at least, to a giant yellow warning sign: caution ahead.