Stock Market at Lofty Levels—–What Should You Do?

by John D. Quimjian | Aug 27, 2014

The easy answer is to stick with your financial plan. Your financial plan should reflect your risk profile, asset allocation, and time horizon. If you will not require the money from your stock profile (individual stocks, ETFs, and mutual funds) for 3-5 years then stick with your target stock allocation. If you are above your target allocation then now is a good time to sell given the recent gains in the market. The tougher question is if you are below your target allocation in stocks. The simple approach is to dollar cost average (12 equal payments) over the course of 12 months while keeping a percentage back to use when the market dips. A more complex approach (for those that have considerable financial experience or through your advisor) is to buy ETFS and sell put options in the indexed ETFs. The put option allows you to either generate income or buy the ETF at a lower price.

The other question is how lofty is the market? That depends where you look. The Dow industrials’ P/E ratio is 16 compared to a historic average of 15. A P/E of 15 also happens to be estimate based on next year’s earnings. Small cap stocks have a P/E of 79 but this drops to 19 on estimated 2015 earnings. The S&P 500 has a P/E of 19 on current earnings and 17 on next year earnings (compared to an historic average of 16). Therefore, the broad market is close to 20% above historic averages and large companies are less than 10%.

From a value standpoint, large companies appear the best. A P/E of 16 represents a 6.25% earnings return to the investor which looks good considering CDs often pay less than 1% and government 10 year bonds are yielding about 2.5%. Even if bonds go up one percent, large company profits look good in comparison. The primary risk to these blue chip stocks is disappointing earnings or significantly worsening geopolitical events.

In conclusion, small companies are currently very highly priced, while many large companies are still offering a good overall return especially in light of the poor yields on CDs/highly rated bonds. Many large US and international companies are still a buying opportunity for long term investors. When the market goes into a correction, these companies will offer a particularly appeal to those investors who have at least a 3-5 year time horizon. One final thought, in the part of your portfolio not allocated to stocks, keep a higher percentage in cash. This can provide buying opportunity and peace of mind. You’re not giving up much given the high price (low yield) of bonds.

The above predictions represent the opinion of John Quimjian, registered investment advisor representative. Written Aug 27, 2014.