Last Wednesday, Federal Reserve Chair Janet Yellen stated that “market valuations at this point generally are quite high,” which might lead to “potential dangers.” In fairness to Yellen, she did hedge by using the word “potential”, but if history is any indicator, Yellen may have just signaled that the market could be moving higher from here.
You see, last year on July 15, Yellen spoke in front of Congress. As part of her comments she stated that the valuation of small-cap biotech stocks were “substantially stretched.”
Immediately, investors reacted by selling biotech stocks. Here is a chart of the iShares Nasdaq Biotechnology Index ETF (IBB) from that day.
Needless to say, her comments instantly spooked the market. However, what happened next may surprise many investors.
Let’s take a look at what has happened to the biotech sector (Symbol: IBB) since she made this statement last year.
Here is a chart from July 15, 2014 through the morning of May 11, 2015:
Those investors who understood the fundamentals and demographics driving the boom in the biotech sector and stayed the course have been rewarded handsomely. Since her original comments on biotech the S&P 500 is up a respectable 6.98%, while the biotech sector has returned a remarkable 36.62%!
So can Yellen do it again? Will the market move higher like the biotech’s did last year?
Clearly, I write this article with a little humor as Yellen is not directly trying to predict the next move in the stock market. Nor should we trade (buy or sell) the market based on her comments. Rather, we need to objectively review the facts as they are today.
To help provide greater insight into the situation, let’s use one of our trusted “rules of thumb” for evaluating the stock market – “The Rule of 20”. The rule of twenty uses the price-to-earnings ratio (P/E) and the core inflation rate to determine whether the stock market is valued fairly.
To calculate the rule of twenty, simply add the P/E Ratio + Core Inflation Rate together. If the resulting number is less than 20, the market is undervalued. If it totals greater than 20 the market has become overvalued.
Today, the P/E Ratio is 18 and the inflation rate is 1.8%. When added together it equals 19.8%. This is nearly twenty. As a result the mark is not over or under valued, it is fairly valued.
So what does this mean?
Well this tells us that US stocks (as measured by the S&P 500) are no longer “on sale”. It’s kind of like going to a store to buy something without a coupon. You can still go buy the item you want, it just will not be a discount to its market price. Same goes for the market.
It’s important to know that a fairly valued market is not an expensive one either. Investors are not having to pay a premium for the items they want to buy.
If the market is fairly valued, what should an investor be doing today?
The answer for most is nothing. Fairly valued markets do not often require meaningful allocation or investment strategy changes. The reason for this is that markets rarely get to fair value and stop going up. When markets hit their peak we expect a euphoric attitude towards the market. We would want to see our “Rule of 20” indicator get in the mid to upper 20’s before we expect to see elevated risk of a market top.
So this brings us back to the original question, did Yellen just signal a buying opportunity?
I think so. Our research continues to give the current bull market the benefit of the doubt. Eventually, Yellen’s warning will come true – Trees don’t grow to the sky, and neither do markets.
However, we continue to stay by our prediction that this market can and most likely will go higher than most think is possible. We feel the market could continue higher for another three to four years depending on future political and economic factors.
With this said, our investment process is not based on predictions, it is based on the facts as provided by our economic and market research. This is why we always say, “If and when the facts change – so shall we.”
That’s all for today’s market commentary. Have a great week and feel free to share this commentary with those you feel may benefit from reading it.
