“Is the market overheated?”

This is the quintessential question that every investor is asking themselves, and their neighbors. Everyone, and their grandmother (Hey, she lived through the Great Depression!), has an opinion. Therefore, I feel that I should chime in as well.

Markets have a natural vicissitude ingrained them. No investment will go up perpetually. However, there is no known perfect market-timing signal. If so, please show me this indicator that predicted EVERY 10% or greater (just to use an arbitrary amount) pullback in history. There are, though, a plethora of pretty good indicators to judge the “temperature” of when the market, an investment, or asset class.

First, let’s define what “the market” is in the above question. People have a tendency to lump a lot of things together and forget about details. Ben Carlson (if you don’t subscribe to him then you should stop reading me right now and do it) showed in a recent article that there are only three of fourteen asset classes up over the past 250 days, as of July 14. There are more than fourteen asset classes, but it’s still a good, broad gauge. Let’s gain a longer time-frame and look back over the last five years. The S&P 500 price (let’s just focus on appreciation and forget dividends) is up around 93%. The EFA index, focusing on developed countries minus Canada (sorry!) is trailing greatly at 27%. The EEM index, emerging markets focused, is DOWN around 10% (remember, take out dividends). The US REITs, which is really just a specific industry of US stocks, has appreciated around 55%. Point is, when people say “the market” is overheated they are, or should be, referring only to US stocks.

Now, are US stocks overheated and overvalued? Carlson, in the same article, makes a great observation in that equity ownership is back to 2007 levels. Oh nooo!! That was RIGHT before the bubble burst! Wait…hold on! He counters that observation with another great point. The average lifespan has jumped from around 60 years back in the ‘30s to 78.8 today. People should probably have more exposure to equities to help them through a longer retirement.

Moving on.

Another person I subscribe to is Wesley Gray. I love his and his team’s work and trust his research. One idea that they have researched is tactical asset allocation. In other words, knowing when to move from cash, to bonds, to stocks, to bonds, to cash, etc. I liked the technique of the 12 month moving average. It looked at the current Shiller CAPE ratio and compared it to the average CAPE ratio of the last 12 months. If the current ratio was higher than the average past 12 months, then invest in 10 year bonds. In other words, get out of US stocks! The study showed that on a risk-adjusted basis and a worst drawdown basis, this rule performed better than just holding the S&P 500. Of course, just like all research, what worked in the past may not work in the future. And there’s always the question of robustness and data mining. I did the June calculation and the rule is saying to get out of stocks. Hmmm…

Another technique that I read about, referenced by Gray, was from the team at Gestaltu. They researched another tactical asset allocation method that utilized real earnings yield. This looked at the inverse of the Shiller CAPE ratio and subtracted year-over-year inflation. In this rule, you would invest in the S&P 500 as long as the valuation was not higher than the 80th percentile (more on this percentile later). Otherwise, hold cash. The results were great from a risk-adjusted return standpoint and a maximum drawdown perspective. The June calculation said to stay in stocks. What….

John Hussman has said again and again in so many articles (I’ll reference his most recent one that I read) that there are two rules investors need to learn. The first, the Iron Law of Valuation, states that “The higher the price you pay today for each dollar you expect to receive in the future, the lower the long-term return you should expect from your investment”. The second, the Iron Law of Speculation, sayings “Risk-seeking and risk-aversion control returns over shorter portions of the market cycle.” His point is that the current amount you will pay for the S&P 500 is so high as to only justify extremely weak returns over the next several years. In other words, yes the market is overvalued. However, his second law states that this “overvaluation” can continue as long as investors are risk-seeking. He believes that is faltering due to his readings into market internals and credit spreads.

So what do I think? It’s hard to argue with the logic of Hussman’s two law rule. This second law overlaps the Gestaltu study, which is why an investor should hold stocks even when the valuation is higher than the 50th percentile. Stocks will continue to go up until they reach more extreme levels of overvaluation. Stocks will also go down until they drop to levels of extreme undervaluation. When it comes to rules-based, systematic investing there are several rules that call for retreating out of US stocks. There will also be several (in my mind possibly a smaller amount) rules that say “Invest more into US stocks”. The worst thing an investor can do is jump ship on a rules-based, systematic strategy that they have been using when they feel it’s underperforming and they start becoming timid. Another bad thing would be for an investor to not even HAVE a rule for investing. If the latter is the case, I can provide several good, fundamental rules-based ways of investing. And please don’t ask your neighbor for a rule…Unless they happen to be Wesley Gray or Ben Carlson.

In my opinion, I’m not sure if the risk with US stocks is worth the reward. This does not mean to run away from US stocks. I will always preach diversification. This does mean I would limit my exposure to US stocks. One strategy I’m utilizing for a client is to lower his exposure to US stocks every quarter that we do not see a double digit pullback. This works for him because he has a large allocation to that asset class and we want to steadily, and systematically, lower our exposure to that asset class. If an investor does not have a large exposure, then it may not be necessary to do anything. Just sit back and watch the talking heads on your TV discuss the exact day (of course no one can get the exact MINUTE correct!) that the pullback will happen.

Adam McCurdy, CFP®, EA

 

As always, this if for informational and educational purposes only. Nothing contained herein constitutes tax, legal, insurance or investment advice, or the recommendation of or an offer to sell, or the solicitation of an offer to buy or invest in any investment product, vehicle, service or instrument. What has worked in the past may not work in the future. Past returns do not guarantee future results.

Adam McCurdy“Is the market overheated?”

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