When I graduated from Shaker Heights High School in 1959, Rocky Colavito and Mike Garcia were still starring for the Cleveland Indians and Paul Brown and Jim Brown were leading the Cleveland Browns.
Over the decades since, every U.S. economic recession has been preceded by an inversion in interest rates, where the Fed forced the rate on fed funds above the 10-year Treasury rate. Today the rate on fed funds continues well below 10-year Treasury rates, with the Fed indicating no immediate change in policy.
I guess conditions could develop that would allow the U.S. economy to sink back into recession without a cyclical downturn in consumer goods new orders or an interest rate inversion, but based on decades of history, what is the probability? And if the economy holds together and consumers continue to consume even at a modest clip, I would expect the bubble condition in the stock market to persist.
Those not investing with caution during this bubble phase in the stock market are liable to take a savage beating when the euphoria ends. The S&P 500 price-to-sales ratio, one of my favored stock market indicators, is at one of its highest levels on record. If the broader market was to revert back to its six-decade average price-to-sales ratio, investors would have to choke down losses in excess of 35%.
Sadly, more and more investors are throwing caution to the wind. Check out my relative performance chart of the speculative NASDAQ Composite Index versus the Dow Jones Industrial Average. As you can see, greed is again the dominant sentiment among the investing public.
What is the best course of action for you to pursue in today’s speculative markets? Cut risk.
Start by eliminating the Netflix (NFLX), Facebook (FB) and Tesla (TSLA) stocks of the world from your portfolio. These are the types of stocks that are most likely to suffer punishing losses when the speculative fervor ends. Next, prune back your exposure to stocks that have gone parabolic.
The stocks where you can look to reduce exposure if you own them are Boeing (BA) and Canadian Pacific (CP). Both are first-class franchises and both companies have favorable long-term prospects. But after some outsized recent price gains, both stocks are poised for a period of stagnation at best and painful correction at worst.
You can see on my Boeing rate-of-change chart that the stock’s annual return is now above my plus-two standard deviation band. When the rate of change on a stock crosses above my plus-two standard deviation band, its future return prospects dim.
Also in the parabolic camp is Canadian Pacific. Over the last 24 months it’s up over 135%. At these levels the stock looks vulnerable to a meaningful correction. Take some profits.