Risk in the stock market has increased

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John Hintz, CFA®
John Hintz, CFA®

For those who follow the stock market on a daily basis, there is no denying the risk profile of the market has increased.  We believe the chance of a five to 10 percent correction in the S&P 500 has increased.  However, if it does occur it will just serve as just a temporary and overdue correction in an extended bull stock market.

Why has the risk of a correction increased?  It all starts with valuation.  Over the past 10 years, the S&P 500 Index has traded at an average price to next 12 month’s earnings per share ratio (“P/E”) of approximately 14x.  Currently, the S&P 500 Index trades over 15x on this P/E valuation multiple.  Thus, stocks appear a little expensive.  Typically, the current small size of the S&P 500 P/E premium to historical averages would not worry us as long as the fundamental tone of the market remained strong.  However, there have been a few chinks in the armor that warrant attention and perhaps will constrain further P/E valuation multiple expansion in the S&P 500 and potentially increase stock market volatility.

What are the potential concerns?  First, the Russia and Ukraine escalating tension is causing stress in the marketplace.  The United States and Europe have placed economic sanctions on Russia.  These sanctions increase the risk of negative economic consequences in Europe.  Given recent weaker economic data signals out of Europe, the threat of an increased negative economic impact from the sanctions is cause for some concern.  Secondly, the United States has recently shown some initial signs of inflation picking up.  This is a potential concern because it could move up the Federal Reserve’s time frame for increasing interest rates.  Any sign the Federal Reserve might increase interest rates earlier than the market assumes is a negative for the overall stock market.

How has Winch Financial changed its portfolio positioning given the new risks highlighted?  Recently, we raised some cash and positioned our holdings more defensively.  While we do not see current events leading to an end of the bull market, we are cognizant that market risk has indeed increased and we prudently lowered the investment risk profiles of our portfolios.  Given the information we have now, we will likely take advantage of a correction in the stock market to increase our allocation to stocks.