Stack on Stocks: A Cautious Bull

02/09/2017 9:00 am EST

Focus: STOCKS

James Stack

President, Stack Financial Management

In historical terms, 2016's healthy 9.5% gain was only mediocre - as over half the Presidential Election years since 1928 had an even greater return, observes James Stack, money manager and editor of InvesTech Research.

Unfortunately, post-election years are often not as friendly for investors. Double-digit losses occur twice as frequently as in election years and the average gain is only 5.2%.

For now, however, the economy is hitting on all cylinders. From large corporations to small companies, confidence has turned sharply higher since the November election, and that portends well for business spending and investment in 2017.

Moreover, any surprises in the business sector over the next few months should come in the form of stronger, rather than weaker, expectations.

Several major leading economic indicators have shaken off recent signs of volatility and weakness, and are now pointing to a continuation of the economic recovery.

Alongside soaring confidence and upturns in other leading economic gauges, our key technical indicators also support a continuation of the bull market over the near-term.

However, the positive economic and technical evidence does not rule out a 5-10% correction sometime in the first half of 2017. Corrections are a natural and healthy part of every bull market as they temper investor expectations and keep exuberance in check.

Stocks are expensive by historical standards, which limits the upside potential for this bull market and increases the downside risk when a bear market does eventually arrive.

The current P/E ratio of the S&P 500 at 25.5 is well above the long-term average of 17.1. In fact, the only times that this ratio has been significantly higher than today were during the Technology Bubble of the late 1990s, together with the distorted period in the subsequent recession, and the 2008-09 Financial Crisis.

Part of the stimulus for the latest rise in valuations is a market expectation for higher earnings power in the years ahead. However, much of that future growth is already priced into the market and current high valuations must be considered a longer-term risk at these lofty levels.

Based on the almost universal bullish evidence  - both macroeconomic and technical - we should expect more new bull market highs this year, albeit with a probable correction or two along the way.

Still, high market valuations and increasing monetary risk must be taken into consideration. Thus, we continue to emphasize the importance of a defensive portfolio strategy and sector selection as we prepare to navigate the final phase of this aging bull market.

Subscribe to James Stack's InvesTech Research here.

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