Executive Summary
- Over the last month, U.S. stock market valuations, using the most historically–reliable measures, have become the highest they’ve ever been. Ever.
- Based on current valuations, the next bear market in stocks may result in losses exceeding 60% from the ultimate top.
- The next decline will be painful for most investors as every bear market tends to be but particularly problematic for folks nearing retirement and those already retired. All their retirement plans may be in jeopardy if they do not take steps to adequately protect their wealth and preserve their financial independence first and foremost!
- There is hope for disciplined investors who understand the difference between a marathon and a sprint! For those investors, the next bear market may provide many attractive, sustainable, and sound investment opportunities at much cheaper valuations.
In a recent Weekly Market Comment, Dr. John Hussman supports the following conclusions (all bolded emphasis throughout is mine)…
At present, the most reliable measures of U.S. equity market valuation – the measures that are best-correlated with actual subsequent market returns in market cycles across history – are 2.75 times (175% above) their historical norms. …the S&P 500 is likely to post negative total returns over the coming 10-12 year horizon, with a likely interim loss in excess of -60%.
Based on the consensus of the most historically-reliable market valuation measures we identify, the U.S. equity market is now at the most offensive level of overvaluation in history, exceeding even the levels observed in 1929 and 2000.
Within the financial industry and academia there are many metrics used to ascertain how expensive or cheap the stock market may be. The goal of the exercise is to inform whether stocks are expensive or cheap and forecast market returns. However, it should be obvious that before any metric is used, no matter how great it sounds in theory, it should be tested to determine its actual correlation to future market returns.
Enter Dr. John Hussman of Hussman Funds. Dr. Hussman recently analyzed fifteen different valuation metrics to determine their actual correlation with subsequent 10- and 12-year S&P 500 returns. I’ve included his chart below, which he sorts in order of greatest correlation to lowest…
The two most commonly quoted in the media are Price / Earnings (trailing 12-mo) and Price / Forward Earnings. Notice these are two of the least reliable measures in the set above.
One of the most historically-reliable valuation measures, listed fifth in the chart above with a -0.90 correlation to subsequent 12-year S&P 500 returns, is margin-adjusted CAPE…
Currently, this metric is the highest it’s ever been exceeding both the Great Depression (1929) and Dot-Com Bubble (2000).
Another measure from Dr. Hussman’s chart is median price / sales. This measure takes the median price / revenue ratio from the S&P 500 stock index components. See below…
The Dot-Com Bubble had some of the most extreme stock valuations in history, but much of that was concentrated in just a few industries in the top few deciles. In other words, there were stocks available that were reasonably valued and offered some protection from the Dot-Com Bubble.
The difference today, as illustrated in the chart above, is that extreme valuations are much more widespread than they were in 2000. In other words, every sector is suffering from extreme valuations. Even those sectors typically considered “safe” are trading at record valuations. In Hussman’s own words…
What’s notable here is that unlike the 2000 peak, when overvaluation was concentrated in the top two deciles of stocks (primarily representing large-cap tech stocks at the time), the current valuation extreme is uniform across every decile. Based on the historical relationship between the valuations of various deciles and their subsequent losses over the completion of prior market cycles, I expect nearly every decile of stocks to experience losses in the 50-70% range as this cycle completes, much like the losses that I projected at the 2000 and 2007 peaks (recall that the tech-heavy Nasdaq 100 lost -83% in the 2000-2002 rout), but with the losses extending to a much broader set of stocks in this instance.
…the extreme valuation of the S&P 500 Index in 2000 was not associated with anything close to the broad overvaluation among S&P 500 components that we currently observe. Indeed, at the 2000 peak, nearly half of all U.S. stocks were at valuations that we viewed as reasonable. This is certainly not the case at present.
The valuation measure with the greatest correlation to subsequent 10 and 12 year returns per Hussman’s analysis (blue line in chart below). Keep in mind the chart below is over a month old so the valuations are slightly more extreme than shown here…
The red line on this chart is plots the subsequent S&P 500 annual total returns. Based on the historical relationship between this valuation measure and subsequent market returns, Dr. Hussman was expecting 0.0% annual returns over the subsequent 12 years (as of 9/18/2017).
As Dr. Hussman warns in his commentary, having a “complete lack of imagination about the range of investor emotions is likely to have brutal consequences.” Furthermore….
One of the challenges with securities, banks, and other objects of finance is that while they actually rest on a very long-term stream of future expected cash flows, investors focus mainly on returns, rather than the quality of those underlying factors. That feature allows enormous departures between what investors think is true and the underlying reality that will unfold over time. Those departures can exist and deteriorate for years before they inevitably become common knowledge. It’s exactly the feature that Ponzi schemes rely on, whether those schemes are sold by crooks or central bankers (and it’s sometimes hard to know the difference).
For a while, Bernie Madoff’s investors felt great about their impressive “returns.” For a while, investors in dot-com stocks felt the same. For a while, investors in mortgage bonds felt the same. But when investors focus on returns rather than the very long-term structure, stability, and even existence of the underlying cash flows, terrible things can happen. All that’s required to get the snowball rolling is the creeping recognition that there’s no “there” there.
In response to the delusion that low interest rates “justify” virtually any level of market valuation, regardless of the growth rate of the underlying cash flows, the speculation of recent years has created a situation where there is effectively no way out for investors in aggregate. Every security that is issued must be held by someone until it is retired. When one investor sells a share, it simply means that another investor buys it. The only question is who will hold the bag.
But not only are valuations the most extreme in history, but investors are extremely complacent. The chart below is the volatility index (VIX) commonly referred to as the fear gauge. Volatility tends to spike when investors are very fearful. Conversely, volatility remains very low when investors are complacent.
Notice the spike in the “VIX” as Lehman Brothers was collapsing in 2008? Notice the lulls in the VIX during the prior two bull markets? Lastly, notice the extreme low in the VIX at present-day?
So presently we have a situation characterized by the most obscene stock market valuations in history coupled with record-low market volatility (i.e. record-high investor complacency). Seems like a dangerous mix.
What Should You Do?
There is hope for those who make appropriate adjustments in advance and understand that long-term investing is a marathon not a sprint.
An extreme bear market can provide very attractive investment opportunities for the years that follow. However, to take advantage of such opportunities one needs to preserve some “dry powder” that can be deployed at a later date when those opportunities arise…much like Warren Buffett did after the financial crisis.
Below I’ve listed some strategies that may help you preserve a little more value during the next downturn that can be deployed when assets are much more attractively priced.
Keep in mind, that your situation is unique from other investors. So it’s important you consult with a knowledgeable, competent advisor to determine which strategies make the most sense for you and to the degree they should be employed.
- Build up greater cash reserves than you would in a more “neutral” environment. For nearly-/ recently- retired folks this implies a couple years’ worth of cash in reserve.
- Underweight stock exposure relative to your long-term neutral target. For example, if you and your advisor have determined your optimal long-term target to stocks is 60% maybe you’re targeting around 40% stock exposure now, merely as an example.
- Hedge some of your stock exposure through hedged equity funds or options strategies.
- Hedge the bond sleeve of your portfolio against credit risk by maintaining high-quality bonds. High-quality bonds have a better probability of benefiting from a “flight to quality” during economic or market stress. Underweight high yield / junk bonds that are typically more correlated with stocks. In times of stress, you want your bond sleeve to be a buoy for the rest of your portfolio.
- Hedge your bond sleeve against the risk of rising rates by shortening the duration of your bond portfolio. Conversely, for very aggressive investors with 70%+ stock exposure consider longer-dated Treasuries within your bond sleeve as those may act as a better hedge against stock market declines than shorter-dated bonds.
- Maintain a small allocation to precious metals (gold, silver, miners, etc…) as a potential inflation and crisis hedge.
- Consider some fixed sources of income to compliment your risk assets.
Again, this is not meant to be an exhaustive list and not meant for you to employ all these strategies simultaneously. Every client situation is unique and presents different challenges and risks that should be addressed. This is merely a brief list to point out some examples of strategies that could be considered to protect against a variety of different risks.
For instance, a retired couple who lives solely off fixed income sources, like a pension or social security, may be able to afford to take more risk with their remaining investable portfolio. That same couple may also have significant exposure to inflation risk since it’s not likely their fixed income source will maintain purchasing power in an inflationary environment so perhaps greater inflation protection for such a couple is in order.
Another couple may have very little fixed income relative to their annual spending and, therefore, are relying almost entirely on their investment portfolio. That couple will be far more vulnerable to market shocks and should consider mitigating that risk as a market shock could jeopardize their retirement / financial independence. This couple may also consider building up greater cash reserves than normal.
Other folks are simply far more emotionally-impacted by market volatility which may cause them to deviate from their strategy when times get tough so even if a particular allocation strategy is appropriate in theory, it may be completely inappropriate in practice. After all, any strategy, no matter how appropriate in theory, requires discipline to maintain and adhere through adversity. That is why it is so important for advisors to know their clients’ true risk tolerance.
Other folks may have a very high emotional tolerance for risk AND financial tolerance for risk. So being a little more conservative may not fit them at all. They may prefer to keep the pedal to the floor.
The plethora of paths available is exactly why investors need a competent advisor to help navigate them through the rest of their lives. A competent advisor understands your situation intimately, the various risks and how to adequately address those risks.
It’s also important that your advisor have the flexibility to implement strategies deemed appropriate for you. Large firms often don’t give their advisors flexibility to deviate much from the firm’s “model.” In other words, a model is created in a committee by a few key decision makers at the firm, which is really just an average of good and bad opinions. That model is then applied broadly across the entire client base with the only variation being the allocation between bonds and stocks. That just won’t do. It can’t do because of the uniqueness of each investor’s circumstances. That’s where being a smaller, nimbler, more flexible firm can be a great asset to an investor.
Disclosures: I cannot provide specific recommendations here because every client situation is unique. This is not intended as individualized investment advice. Always consult your advisor to help identify optimal strategies for your unique situation. Past performance is no guarantee of future results.
