Investors generally believe prevailing market conditions will continue into the future, especially at the extreme ends of the cycle, but the reality is the stock market is counterintuitive, tending ultimately to inflict the maximum amount of pain on the largest number of investors possible, and cyclical, predisposed to mean reversion. The US averages have seen 3 major crashes in the last 20 years (2000, 2008, and 2020), and with stocks again at all-time highs, today many notable pundits are sounding the alarm. What are the reliable indicators, what are they saying, and how can you wisely prepare for what lies ahead?
The most basic valuation metric for stocks is the well-known price-to-earnings (P/E) ratio, indicating the number of years it takes for a company’s present earnings to substantiate the price. Today the P/E ratio on the S&P 500 is 2 standard deviations higher than its historical mean, and since 1950 was only exceeded at the peak of the dot com bubble.
The widely acknowledged Schiller Cyclically-Adjusted P/E (CAPE) Ratio uses a 10 year average of inflation-adjusted earnings to provide an accurate longer-term picture of market valuation. Since 1880 the ‘Schiller CAPE Ratio’ was only higher just prior to the dot com bust.2
Debt drives the economic landscape, and when creditors smell harder times they demand higher rates, especially from “junk” bonds (rated below BBB- on the S&P Scale). A spike in junk yields generally precedes an economic downturn, and would be a strong signal for near-term trouble. Junk bond yields are presently at multi-decade lows due to the unprecedented stimulus following the Covid19 outbreak, and are not yet sounding the alarm.
The valuation of a company is best understood by its insiders, and when they are selling, investors should take notice. Recently insiders have been selling their own company’s stock at a pace not seen since the 2008 crisis.3 Additional strong indications the market may be approaching a multi-year high include wild speculation by novice investors, extreme valuations ascribed to “Zombie” corporations, and record margin investing.
Successful investors never take an all or none approach. America’s investing environment continues to favor the stock ownership of promising and well-managed corporations, and always will. Concurrently, huge bubbles exist in many asset classes, and our nation is burdened with a debt load it can never honestly repay, a fact America’s creditors may soon wake up to. In light of these facts, I suggest you diversify income sources, pay down debt, build cash, know your tolerance for volatility and honor it, focus on capital-efficient, dividend-paying businesses, diversify your capital, include a chaos hedge or two, manage position sizing, have a well-defined exit plan on non “forever stocks”, and if you are able, dollar cost average the next decade in an effort to lower your average cost for shares.
Think about it, sorry for going so long today, and have a blessed Independence Day celebration with your family! Shaun
“The public buys the most at the top and the least at the bottom”
~Rule #5, Bob Farrell’s 10 Rules of Investing
1,2,3 TRADESMITH DAILY, “How to Detect a Market Crash”, by Justin Brill, June 30, 2021
The opinions voiced in this material are general, are not intended to provide specific recommendations, and do not necessarily reflect the views of LPL Financial. The economic forecasts set forth in this commentary may not develop as predicted.
Dividend payments are not guaranteed and may be reduced or eliminated anytime by the company.
Dollar cost averaging requires continuous investment in securities regardless of fluctuation in price levels of such securities. An investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.
All investing involves risk including the possible loss of principle. No strategy assures success or protects against loss.
High Yield (junk) bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit and liquidity risks than those rated BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
The S&P 500 Index is an un-managed index which cannot be invested into directly. Un-managed index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment, and past performance is not a guarantee of future results.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
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The opinions voiced in this material are general, are not intended to provide specific recommendations, and do not necessarily reflect the views of LPL Financial. The economic forecasts set forth in this commentary may not develop as predicted.
