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Portfolio Update

Melting Up

By Elliott H. Gue, on Jan. 26, 2018

Unless you believe that the economy will slide into recession over the next 12 months, it’s most likely too early to call time on the bull market in US equities.

Our indicators suggest that the risk of recession over the next 12 to 18 months is low and that the current economic expansion, though long in duration, is younger and less advanced than it appears.

Consistent with our view that this is a late cycle “melt-up” bull market and returns are likely to exceed the long-term average, we’re looking for the S&P 500 to return between 15 and 20 percent for 2018.

We don’t dispute that stocks look expensive, with the S&P 500 trading at its most elevated valuations since the late 1990s. And valuation matters a lot over the long haul.

(Click to enlarge.)

This chart plots the trailing price-to-earnings (PE) ratio for the S&P 500 (horizontal axis) compared to subsequent 10-year annualized returns for the S&P 500 (vertical axis).

The relationship is clear: When you buy the S&P 500 at a high PE ratio, you can expect sub-par returns over the long haul. Conversely, when you buy stocks at relatively cheap valuations, your long-term returns from holding stocks are likely to be above the 50-year average of 11.7 percent annualized.

How accurate and reliable is this simple valuation technique when it comes to predicting long-term stock market returns?

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