Should you stay in the stock market?

Image by Ahmad Ardity from Pixabay

By Elliot Raphaelson
Posted on October 08, 2021

Many readers have written recently asking if they should be reducing their allocation to the stock market because of the excellent performance over the last few years.

I have always recommended re-balancing your portfolio once a year. I do re-balance myself, sometimes more than once a year.

Stock markets rarely go up continuously, so it does pay to be prudent and not become too enamored by excellent stock market gains. There will always be periods when stock markets will fall in value.

In the long run, stock market prices will be determined by corporate profitability. On that basis, you can be optimistic, at least in the short-run.

In a recent Barron’s article, Leslie Norton interviewed Ed Yardeni, the President of Yardeni Research, who has an impressive background and is well-respected in the industry. Yardeni has been bullish about the stock market for some time now, and he has been justified in doing so based on market performance.

Reasons to be bullish

Here are some of the reasons he continues to be bullish:

He noted that second-quarter profits were on track to increase by a record high [which they did]. He pointed out that companies reacted to the pandemic by cutting costs, and profit margins increased as well as sales. There is a backlog of orders currently, which is another very positive indicator of increasing earnings growth.

Yardeni indicated that Federal Reserve policy has helped the stock market and, as a result, price earnings (P/E) ratios did not fall as much as you would expect in a period of recession.

Although the P/E ratio is high, in Yardeni’s opinion the high ratio is justified because of the Fed policy and because earnings prospects currently are very good. He believes that the stock market will continue to do well in the near-future because of the prospect of higher earnings.

Yardeni went on to forecast a 5,000 level for the S&P in 2023. He expects earnings per share in 2023 to be approximately $230/share at year-end. (Most analysts predict that earnings would average $200/share at the end of this year and $219 at the end of 2022.)

Although he doesn’t expect earnings growth in the third and fourth quarter to be as good as the second quarter, earnings will be at record levels, and that should be a good omen for market prices.

Yardeni is not very concerned about inflation, because he believes that productivity will increase by 4% by the middle of the decade, and will stay there a while.

He anticipates that the labor market will remain tight and corporations will have to increase wages, but that the improvement in productivity will outweigh the increase in wages. He predicts that wages will increase faster than prices, and that the result will be higher profit margins.

He doesn’t believe that there will be significant economic risks as a result of COVID-19, because he believes that the Delta variant will lead more people to be vaccinated, and that is a positive factor.

Entrepreneurs create prosperity

Yardeni discussed a new book he is writing titled In Praise of Profits. In the book, he points out that the S&P accounts for “only about half of national corporate profits.” A significant portion of profits is derived from S corporations, which aren’t publicly traded and don’t pay corporate taxes. The profits are distributed to shareholders, who pay personal taxes on the dividends and income.

In addition, there are other “pass-through businesses,” and if you add all of them, there are 36 million business entities owned by one or a few shareholders that add to overall employment.

In summary, he believes that there is a great deal of entrepreneurship in this country that is not appreciated, “particularly by the progressives.” He believes this entrepreneurship has created a great deal of prosperity in the country.

Yardeni advises investors to own companies that are either providing improved technology, or using technology heavily to run their business. He recommends investors continue to have technology stocks in their portfolios.

For now, he recommends overweighing U.S. stocks. He believes the valuation on small and mid-cap stocks is historically low relative to the larger-cap stocks.

In summary, he believes, as I do, that you still need a high percentage of common stocks in your portfolio.

Elliot Raphaelson welcomes your questions and comments at raphelliot@gmail.com.