There is extraordinary risk in the stock market now. Expectations are high, which leaves the market vulnerable to disappointment. Sentiment measures are at historic high levels of bullishness, and the put/call ratio is back to where it was last spring before the 15-20% drop in stock prices.
This optimism also is evident in expectations for earnings growth. Earnings growth of 19% expected over the next twelve months for the median S & P 500 company is among the highest levels since 1980. This also occurred at the major market tops of 1973 and 2008. Recent reports from the Producer Price Index input costs and the Philadelphia Fed show input prices rising at an unusually rapid rate. When that has happened historically, margins have been squeezed and earnings have fallen short of expectations. After a doubling—or more—in stock prices since the low of March, 2009; sentiment at high levels; and cyclically-adjusted earnings that place valuations at historically high levels, a cautious strategy makes sense. Tomorrow I’ll discuss some appropriate strategies.