Recency Bias and the Stock Market

The first half of 2017 has been an amazing period for the United States stock market. Broad market indices are up over 10 percent year-to-date and volatility has been historically low. The VIX - a measure of expected market volatility over the next month - just hit a 24-year low. Should investors be worried about the market?

Two fundamental factors are driving the current market exuberance: low interest rates and strong corporate earnings. Should either of these factors change, investors could see an end to the market rally. As is always the case, no one knows how severe that end will be or whether it will be sudden or gradual.

Interest rates are near historical lows and there is scant evidence to indicate they will rise dramatically in the near future. In fact, the consensus in the financial markets is that there is only an approximately 50 percent probability that the Fed will announce a 25 basis point interest rate hike prior to year end. The CME Group publishes a FedWatch tool that determines the current probability of rate hikes by looking at the prices that Fed fund futures are trading for in the market. Currently, the FedWatch tool indicates an approximately 3 percent probability of a rate hike next week, an 8 percent chance of a hike by September, a ten percent chance of a rate hike by November, and a 52 percent chance of a rate hike by the December Fed meeting. If any rate hike occurs, it will likely be near year end.

With about ten percent of S&P 500 companies having reported earnings, according to Zacks, total earnings are up nearly 12 percent over the same period last year. And, 80 percent of companies are beating analysts' earnings estimates. The bottom line is that corporate earnings are strong.

Market pundits often use broad valuation measures in stating their case that stocks are improperly priced. Case in point today, many are pointing to the fact that the S&P 500 is selling for a 25.9 multiple of earnings -- markedly higher than its historical norm. It should, however, be noted that this P/E ratio is based upon trailing twelve month earnings. When you calculate the P/E based upon the next year’s expected earnings, a much rosier picture emerges. According to JP Morgan, the current forward P/E ratio is 17.5, much closer in line with the 25-year historical average of 16.

Stock investors are prone to overweight the immediate past and expect it to continue into the foreseeable future -- a behavioral finance malady referred to as recency bias. What will the market do in the next few months and years? I would point to the wisdom of the original J.P. Morgan (John Pierpont), who answered that question both accurately and simply: "It will fluctuate."

While predicting the future direction of the stock market is a loser's game, investors would be well advised to closely monitor interest rates and corporate earnings to get a gauge on the health of the stock market. When either or both of those factors turn, the market environment will likely become much more challenging.

This post was published on the now-closed HuffPost Contributor platform. Contributors control their own work and posted freely to our site. If you need to flag this entry as abusive, send us an email.