A few weeks ago we discussed our aging bull market in U.S. stocks, and over the past month this trend has been affirmed.
We discussed how at later stages in a bull market, defensive stocks in more conservative industries begin to assert themselves and take a leadership role in the market.
The flip side of this coin is observed in the behavior of the high flying growth stocks getting all the attention at earlier bull market stages. These stocks tend to become volatile and can seem to do nothing to please investors.
Company stocks are valued in the context of the company’s profits, or earnings. The ratio of profits to stocks price is called the price to earnings ratio (PE) ratio. Turn on any financial media outlet and there will be constant talk of the PE ratios, most often referred to as valuation. The higher the PE ratio, the more overvalued a stock is perceived to be. In very real terms, valuation refers to the number of year a company would need to be owned before the price paid for its stock is recouped through the earnings generated by its operations.
When a bull market is young and spry the world is perceived as full of opportunity. Companies in emerging industries or those showing great improvements in existing business models are highly sought after and become the darlings of investors. In the current market cycle companies like Tesla, Twitter, Facebook, Whole Foods Market as well as many biotech companies fit this bill.
These stocks will often trade at valuations well above 30, and sometimes above 100 (an “average” PE ratio is about 17). More conservative investors look at these valuations and cringe, wondering how these levels can ever be justified. But aggressive investors look at the profit growth and potential represented by these businesses. They say when profits or sales are growing by 50 percent to 100 percent a year, why do current profits even matter? These stocks are about the future, and the future is bright. And in some market environments these investors are right, opportunity does trump results and excitement does trump logic.
Over the long-term, however, I share the belief the market is rational (definitely not over the short-term). As a rational pricing mechanism, valuation levels tend to revert to historically typical levels over time, and as the market moves through its various cycles the paradigm investors use to evaluate earnings and earnings growth changes.
I believe we are in one of these transition periods right now. The high flying growth stocks of 2013 have become very volatile and a number have lost more than 25 percent in the past month. Now don’t get me wrong, many of these high flyers are my favorite companies and I continue to believe as businesses these companies are going to redefine much in our lives. But as an investor, it’s important to pay attention to the psyche of the market and as these stocks come down in value, caution is warranted.