Sell in May and go away? A look at the risk / reward

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The total return for the S&P500 year-to-date in mid-April is 16.6%. Truly fantastic performance for any year. Clearly, its hard to see whether the gains will continue. The long-term rate of return for the S&P (including dividends) is 9.4% (based on data sourced from NYU). That means this year is clearly above average. Then again, in the past 91 years, how many years have had a higher return than 16.6%??

Well, that may piece of information actually be surprising to hear. There have been 39 other years when the total return on the S&P was higher than 16.6%. That’s about ~40% of the years from the available data!

Clearly, part of the reason for this recent surge was the sell-off in December, where stocks declined nearly 20% from peak-to-trough in just one quarter. The decline was quick and steep and the snap back has been quick and steep as well. We still haven’t recovered to those peaks yet, so a bullish investor could also say we could at least see a couple more points of total return this year from that.

All that said, I have to ask what the risk/reward is at these levels? Is there valuation support?

The consensus earnings estimate for the S&P in 2019 is $164/share. Let’s break that down compared to current trading levels and what that implies (i.e. is the market cheap on its face).

The long-term average P/E multiple is around 15.0x , so this would imply… no the market is not that cheap.

That said, Peter Lynch’s old rule of thumb for if the market was cheap was 20x minus the 10-yr treasury rate (a proxy for inflation). That would put us around 17x-18x. Therefore…the market still doesn’t look that cheap now.

But what if we look to 2020? The market is forward looking after all.

What is interesting to me is that the 2020 EPS estimate is $184 vs. $163 for 2019. That means Wall Street is expecting a pretty strong rebound in earnings growth, roughly 12.9%. That seems pretty lofty, but if they’re correct, that helps explain why the multiple for 2019 is so high.

But even if it is right, the upside for the next 2 years seems pretty capped. Wall Street also has a tendency to reduce estimates, right up until the quarter, which allows for more “beats”.

I could of course be wrong though. And I probably am. There are more than a couple ways I could be wrong, but for me it means pulling back a bit on my risk.

To be clear and candid though, I would never recommend selling on this. There is a great blog post by Wealth of Common Sense blogger, Ben Carlson, that helps reinforce that point. In that, he highlights the story of Bob, the markets worst timer (essentially he only invests at the peaks). I won’t spoil it for you, but everyone should go read it here. The story has had a long-term impact on me.

JP Morgan also publishes a slide on missing the market’s best days and the cost of being out of the market vs. sitting idle. Look at the difference of just missing he best 20 days of the market out of 20 years! That is missing 0.27% of the total days (20 / 7,301). And note how close together the best and worst returns were (in the box callout).

My takeaway from that is: even if you can call the top, being able to call the exact bottom would be even harder.

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