Our investment objective is simple. We strive to outperform the market indices over longer time periods, after all fees, while taking less risk. While it’s easy to spot bubbles or buying opportunities in retrospect, there is no such clarity “in the moment” and we are forced to make prospective decisions about where to be invested. Without the benefit of hindsight, market risks are of paramount concern to us.

A good place to start when assessing risk is to look at the historical fundamental relationships between stocks’ characteristics and their prices. The best-known fundamental is the “price-to-earnings ratio” or the “P/E ratio,” which is a good measure of stock valuations as it indicates how many dollars investors are willing to pay in return for a dollar of earnings.

The following chart shows the historical P/E ratio history for the S&P 500 (an index of the 500 largest US companies’ stocks).

Source: Standard & Poors

The current P/E of just over 18 is only slightly above the historical average, a fact that doesn’t seem too worrisome and has lead many analysts to conclude that stock prices are reasonable.

Stock prices, however, are only half of the P/E equation. The reason the P/E seems reasonable is not that stock prices are low, but because earnings are at record highs:

Chart courtesy of Crestmont Research

The above chart clearly demonstrates not only that earnings are high, but that they are mean-reverting, which is another way of saying that if they get too high they will eventually decline, and vice-versa. This makes perfect sense: in a capitalist system, profits can only get so high before competing businesses enter the scene and start cutting into profits.

Considering the record-setting earnings environment and the tendency for earnings to revert to (and through) the mean, that 18 P/E ratio suddenly looks a lot less appealing.

One way to smooth out the effects of earnings cycles is to calculate the P/E using earnings from the prior 10 years, rather than just from the prior year as is typical. By this measure, US stocks look quite expensive. In fact, this measure indicates that the current valuation places it in the most expensive 20% of S&P 500 valuations over the past 80 years -- a circumstance that has typically lead to poor long-term returns. (GMO Quarterly Letter – 10/31/06)

Of course, overpriced markets can stay that way for a long time and can often get even more overpriced. Our concerns at this point stem from more than just valuation.

The fact is that the current bull market is getting fairly long in the tooth. Consider that since the early 1970s there has been a decline in the Dow ranging between about -16% to -45% every 3 years or so, with the exception of the 1990-1998 period. It has now been over 4 years without any such correction.

Chart courtesy of Franklin Templeton Investments

The length of the bull market has led to a level of complacency and widespread optimism that is often seen near market tops. None of this guarantees an imminent downturn, but it does raise our level of concern.

We have some specific reasons to believe that this period will not prove to be an exceptionally long correction-less period such as we saw from 1990-1998. One such reason is the downturn currently taking place in the housing market.

Rising home prices have been a huge stimulus to the economy in recent years as people borrowed against their homes in order to increase spending. With prices now flat or declining, depending on what area of the country we look at, that stimulus is disappearing and many people in the real estate and construction industries are losing their jobs or seeing incomes fall. A consumer spending slowdown, with its attendant downward pressure on corporate earnings, could soon result.

Between high valuations, an aging bull market, excessive complacency, and a deteriorating outlook for earnings, we believe there to be a significant amount of risk in the broad US stock market.

As we noted earlier, without the benefit of hindsight to guide our investment decisions, market risks are of paramount concern to us. In the next article, we will outline our approach for investing in a market environment such as this.