Our active model retirement portfolios continue to outperform Target Date Retirement Funds and leading investment newsletters. These portfolios will carry greater weight as we’re once again approaching a tipping point for U.S. Stock Investors. With the recent price recovery, the U.S. stock market is again at historically high valuation levels.
This makes it a particularly dangerous time for individual investors as they have the highest percentage of their total assets allocated to stocks over the last four decades. In addition, borrowing to gain further leverage is at historically high levels as evidenced by the NYSE Margin Debt Levels.
This is partially due to investors wholly buying into the myth of passive investing. Financial planners want you to believe that all you have to do is passively invest a large percentage of your retirement funds into equities and over time, you’ll achieve an average annual return of 9% based on historical numbers and retirement comfortably. It doesn’t work that way.
One thing that I try to drill into individual investors heads is the myth of “passive investing”
Wall Street would love you to believe that passive investing cures all ills because it limits their liability, increases the amount of your assets they get paid to manage and thus creates higher profits for them in the long-term. It’s easy for investors today to buy into the passive investing theory because it’s simple and they’ve never had to live through the dismal returns of the stock market from 1896-1932 or 1962-1974. They’ve also been lulled into a false sense of security after the last two recoveries due to unprecedented central bank intervention.
Here’s where passive investing really fails investors.
When stock market valuations are at historical highs such as they were in 1998-2000 and 2007-2008, stock market returns going forward are NOT projected to be 9%. Projected returns were 2% a year or less over the next 2-10 years. Throw in a negative economic event such as the dot com bubble or financial collapse and short term returns can be disastrous.
We are now in such a time.
After the recent recovery, 2016 stock valuations stand at historically high levels. Despite all the “fear” in the market, investors are taking on more risk than ever. They are repeating the exact same behavior they did in 1998-1999 and 2007-2008 when stock market valuations sat at today’s level.
Are you willing to take on such risk? Or do you need to make adjustments your investment portfolio?
Those questions are even more pertinent if you’re close to retirement or a risk adverse person.
U.S. Stock Market
With the Tobin Q ratio, median Price-to-Sales ratio and debt margin again sitting near historical highs at a time when earnings are decelerating, I don’t see any reason why we will see much price appreciation in the stock market.
The last three times the market rallied to reach such lofty valuations (September 2014, July 2015 and December 2015), the market declined by at least 8% or more in the ensuing couple months. Consider the following when measuring the current risk in the market.
- This is the fourth consecutive quarter of corporate sales declines.
- I’ve warned that the P/E ratio can be misleading due to financial engineering. This is evidenced by reported earnings being 25 percent lower than pro forma figures. Additionally, the gap between GAAP and adjusted [non-GAAP] EPS is the widest since the last crisis. Companies are trying to “inflate” earnings.
- David Stockman, former Director of the Office of Management and Budget under President Ronald Reagan recently pointed out that GAAP earnings have already declined 18% from their peak levels, leaving the stock market trading at 22 times earnings. While this might be acceptable in a high growth market, it leaves stocks extremely overvalued on an historical basis based on today’s earnings growth projections.
- In the last 12 months there have been 10 month-over-month declines in Industrial Production. This has never happened outside of a U.S. recession
- Art Cashin, shared the following ominous insight. “Jason Goepfert, the outstanding pilot of Sentiment Trader dug into his incredibly extensive files to uncover a rather rare condition. He noted that the indices have had two 10% corrections in a rather short span. That has only happened three times in the last 100 years. Unfortunately, those occurrences were in 1929, 2000 and 2008. As you may recall, those were not particularly good years for the bulls.” While 3 occurrences are too small a sample set to draw conclusions from, I feel it is worthwhile to keep in mind.
- Profit margins typically top out prior to the stock market. Profit margins peaked four years ago and have fallen steadily since leading to eroding top growth. Rising wages will further erode already declining corporate profit margins. Corporations have combatted this with cost cutting and stock buybacks to bolster bottom line growth (earnings per share). 50% of the inflows into the stock market the first quarter of 2016 were due to stock buybacks alone. This cannot continue forever.
The bond market typically is a better indicator of the health of the economy and is almost always proven right in the long-term. The bond yield is hinting at further underlying weakness in the economy as the 10-year Treasury is lower than the yield for the S&P 500.
There is growing concern regarding possible deflation while at the same time we are seeing core inflation increase. In other words, investors are getting mixed signals.
Many European countries have instituted negative interest rates with limited success as they combat possible deflation. There have been unintended consequences with financial institutions baring most of the pain while investors pile more money into cash.
We aren’t concerned about any signs of deflation until we see it go above 2-2.5%. Below 2.5% there seems to be minimal effect on stock or bond prices.
The Federal Reserve itself pays most attention to the Labor Market and Core consumer inflation when it makes it determination to raise interest rates. Wage growth has been steadily increasing which has led to core inflation rising above the FEDS 2% target. While most don’t anticipate a rate hike until November or December, the FED may be forced to act sooner if this trend continues.
Tip: Treasuries are negatively correlated to stocks which essentially means that they don’t move in the same price direction and are considered a safe haven when stocks appear overvalued.
Due to rising commodity prices, emerging markets had a bear market rally leading to a strong first quarter. That said, there’s not much data that points to a sustained rally. China’s growth rate is still slowing, Russia is expected to see a negative GDP this year and Brazil and Argentina among others are struggling with high debt levels. The one bright spot appears to be India.
With the recent rise in prices, our financial models going forward continue to show a high risk – low return environment going forward based on current valuations and profit levels for the U.S. Stock Market. Therefore we continue to suggest following strategy number one to improve long-term returns by switching to a more conservative portfolio.
If you’re an aggressive investor – move to a growth portfolio, if you’re a growth investor move to the balanced portfolio etc, until company earnings catch up to current stock market valuations or the stock market corrects to more neutral valuation levels.
Although we can’t predict what will happen in the short-run, we can look at long-term probabilities to help you make sound investment decisions based on your goals and personalities. Again, we don’t predict the future; we only look at probabilities going forward. It’s up to you to decide how much risk you want to take over the next 3-5 years. Based on current market conditions, it appears that taking on a more conservative portfolio will provide long-term rewards.
Using strategy number one during market extremes such as this has been one of the easiest and most effective ways to reduce overall portfolio risk while increasing returns. It helped investors achieve superior returns in 2008-2009 and we’re expecting it to do the same here.
For the past couple year’s readers have been rebalancing their retirement portfolios by allocating a higher percentage, or in some cases, all of their new investment dollars to bond funds to keep their investment percentages in line with their goals.
If we do face a steeper stock market correction, you should keep a close eye as to when you should again shift the percentage of new investment funds to maintain your investment portfolio percentages between stocks and bonds.
Remember, typically the easiest and most cost effective way to maintain your correct asset allocation (portfolio balancing) is to direct new investment dollars, dividends, and other cash flows into the most underweighted asset class to maintain proper diversification.