March 6, 2017

Market timing is tricky because if you missed the best 40 days in the last 20 years, your annual returns quickly turn from positive 8.19% to negative -1.96%.

But the fact remains that we are looking at a euphoric market with shaky economic foundations.

You don’t have to get out of the market. Getting out of overvalued stocks should suffice.

Introduction

With every new high reached by the DOW or the S&P 500, the market gets riskier. However, I don’t want to be another analyst that just predicts doom and gloom so today I want to discuss the best risk reward allocation and what an investor can do in these exciting but risky times.

Where Is The Market Now?

If we take a look at a normal stock market cycle, we saw capitulation in 2009 and that was followed by hope which lead into 2011 when we saw the first sell-off and bear trap, then came enthusiasm which slowly transformed into greed as valuations crossed 20 in 2015. As the current PE ratio is close to 27, we are in a delusion and “New Paradigm” euphoric state where it is expected that the economy will grow at 4% for the next decade and where economic fundamentals like potential inflation, and certain higher interest rates alongside ballooning central banks’ balance sheets, ballooning credit and declining productivity suddenly don’t matter anymore.



Figure 1: The stock market cycle. Source: RyKnow.

We are in a “mania” market phase and that is a fact, but I, and for that matter any other human being, can’t time the market. I don’t know when people will sober up and realize that 4% economic growth isn’t sustainable for more than a few years and would lead into a deep recession as the only way to reach 4% is by using lots of leverage. I don’t know when the market will realize that a PE ratio of 27 is too much even for 4% growth in perpetuity. And I don’t know when this euphoric state will turn into a panicky one where most of the current market investors led by their euphoric emotions will capitulate in despair and sell for whatever price. However, what I can do is look at economic signals in order to position myself in a way that I get the highest possible value from my investments in my investment horizon.

Mixed Economy Signals

You would imagine that with the S&P 500 up 15% in the last 3 months, the economy would be booming. However, that isn’t exactly the case.

Cumulative federal debt has doubled since 2010 which means that any future additional infrastructure investments, lower taxes, or any kind of higher spending would involve more borrowing further increasing government debt.



Figure 2: Total public debt. Source: FRED.

The situation doesn’t look much better on the business and GDP side. Credit has boomed in all sectors while GDP has been growing at a consistently slower pace.



Figure 3: All sector debt and GDP. Source: FRED.

From the above I conclude two things. If the FED increases interest rates, the economy, which is driven by debt, will suffer. Not only that, but corporations that are high on cheap money will also have to sober up, and eventually the picture isn’t going to look nice. The only problem with the above is that I don’t know when this is going to happen, only that the situation as is, is unsustainable.

On the other hand, the economy is showing positive signs which is logical given the above increases in debt.



Figure 4: U.S. GDP annual growth rate. Source: Trading Economics.

Economic growth, high liquidity, and low interest rates make many investments attractive, that in consequence lead to higher employment.



Figure 5: U.S. employment – all employees. Source: FRED.

As long as there is more debt and cheap money without inflation, and the economy continues to grow alongside employment, stocks could reach higher and higher levels. A big problem will arise when the economy stops growing and employment falls. This is inevitable as it is a natural process. However, the question remains, what can you do?

What Can You Do?

Unfortunately, timing the markets is impossible. Those who have tried to time it exited the S&P 500 back in 2011 or 2012 and have missed out on the huge bull run since then.

Exiting now might prove a smart idea, but it could also be costly because the market could just continue rising as there is enough liquidity and positive expectations. Further, if you just miss a few of the best days on a stock market, your returns decline significantly.



Figure 6: Annual returns decline by 10 percentage points if you miss the best 40 days in 20 years. Source: Index Fund Advisors (IFA).

However, the returns that you can get if you manage to time the market are very tempting. But, as the market gives positive return on aggregate, it’s costly to stay out of it because the market might never go below its current level.



Figure 7: Annual returns more than double if you miss the worst 40 days. Source: IFA.

So, if getting out of the market isn’t a smart option, again, what can you do?

First, understand that you don’t own stocks, but businesses, and your investment returns will be correlated to the future performance of those businesses in relation to the price you paid. Now, if you feel comfortable owning a business like Johnson & Johnson (NYSE: JNJ) at a PE ratio of 21.06 and a dividend rate of 2.58%, then you shouldn’t sell. Reinvesting the dividend will give you excellent returns over time. Which brings me to my second point, time.

Look at your portfolio through your investment horizon glasses. If you are investing with a goal to comfortably retire 15 or 25 years from now, then you can allocate your monthly investments into sectors that are cheap at the moment, like commodities, pharma or some emerging markets. You may have bought JNJ in 2011 when it was below $50, so you don’t have to add now in order to diversify. Even if a crash comes around, your return will remain positive while you will be able to buy more of JNJ thanks to your dividends.

Available monthly investment cash can be allocated to investments that don’t carry the high risk the current market does. There are shorter term investment opportunities that can deliver satisfying returns like options, arbitrage investments, cheap global dividend yielders, or special situation investments. Such investments require a bit more work and research, but I think they are worth it as the general market is very risky at the moment. Another good idea is to own some gold stocks as protection from high inflation levels, and ballooning deficits and central banks’ balance sheets.

Conclusion

In the long term, everything levels out, from business cycles to specific sector cycles to stock market cycles and economic cycles. Everything is perfectly correlated to underlying fundamentals in the long term. So, if you want to sleep well, just look at the fundamentals of the businesses you own. If you are satisfied with those, then a potential 50% market decline would only make you happier because you can buy more of the same assets you already have.

If you don’t like the assets you own but are holding on to them because they might go higher, then you’re gambling. Therefore, gambling rules should apply. I don’t discuss gambling rules as what I write for Investiv Daily is focused on investing, but we can make an exception: Be sure not to enter the casino with more money than you can afford to lose.

Thanks to the global world we’re living in, it’s possible to have a well-diversified portfolio that is less risky than the current S&P 500 while also offering much better future returns. Therefore, my conclusion would be: you don’t have to get out of the market, just out of extremely overvalued stocks.