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Sound Advice: July 20, 2022

Tops and Bottoms 

With all due respect to those who in hushed tones profess to know the precise levels of high and low points of the investment markets, no one has such a vision of the future.  At best, this information is available in retrospect, not in advance.

Over the latest decade and a half, there have been four market tops and three market bottoms.  The fourth bottom may have already occurred or it still may lie ahead.  The first of these peaks was on March 24, 2000, just before the market was en route to a 49% plunge, which continued until October 9, 2002.  Those were the days of the dot.com companies with great stories, but no profits.

The second peak was on October 9, 2007, the precursor to a 57% drop in the averages, which ended on March 9, 2009.  That 17-month pullback reflected the chaos in the financial markets that nearly brought the system to a halt.

From that time until February 19, 2020, the Standard & Poor’s Index rose 401% before hitting the wall of the coronavirus pandemic.  In the five weeks that followed, the S&P nosedived 34%, then more than doubled by the beginning of the current year.

The lesson to be learned here is that of relative valuations.  In the latest quarter-century, the average valuation of the S&P Index has been 16.9x earnings.  What does that mean?  This index consists of large and small companies.  The earnings of the index reflect the trends in the profitability of those companies.  What’s important is the rate of change over time.  As growth accelerates, valuations increase.  And vice versa.

During recessions, growth disappears temporarily and valuations shrink.  When growth resumes, valuations widen.

So it should come as no surprise that during the low growth decade from 2000-2010, the index valuation shrank from more than 24 times to less than 10 times in the midst of the banking crisis.  By last year, thanks to a subsequent acceleration of corporate growth, it had worked its way back over 22 times, once again in rich territory.

Although high valuations alone do not lead to market weakness, unfavorable economic and geopolitical events often light the spark that sends the indexes lower.  That has been the case this year.

On June 30th, the valuation of the S&P had dropped to 15.9x earnings, which is not far from the low points of recent market bottoms.  Whether there’s more slippage ahead remains to be seen, but it seems likely that we are in the neighborhood of where the next advance will begin.

N. Russell Wayne, CFP®

Sound Asset Management Inc.

Weston, CT  06883

203-222-9370

www.soundasset.com

www.soundasset.blogspot.com

 

Any questions?  Please contact me at nrwayne@soundasset.com

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