Enjoy big profits today, but plan for weakness tomorrow … signs of a top? … getting your portfolio ready

When’s the best time to buy an umbrella?

When it’s sunny and beautiful? Or when it’s a stormy, torrential downpour?

Obviously, no one wants to find themselves caught in a monsoon without cover. But when it’s gorgeous outside, who wants to waste their time buying an umbrella? You want to be at the park, enjoying the sunshine.

Today, it’s about as sunny as it can get in the markets … but it’s time to force yourself to go buy that umbrella.

Now, as we’ll explain more in a moment, this doesn’t mean “sell all your stocks and run for the hills.”

In this case, an “umbrella” means having a plan for your portfolio — and that plan will be unique for each individual investor.

Every investor should move into this year thoughtfully, fully aware of the risks. That means knowing what you’ll do when presented with any one of a wide range of potential market situations in 2021 — from up big, to down big, to sideways.

Bottom line, it could stay sunny all year long, and we certainly hope it does.

But if unexpected, dark clouds appear from nowhere and begin soaking all those unprepared people in the park, you’re going to be glad to have that umbrella.

***Signs of a dangerous market

That’s an ominous subhead.

Perhaps a bit too “gloom and doom” and fear-mongering?

Possibly. After all, some of our InvestorPlace analysts like Matt McCall and Louis Navellier are incredibly bullish on 2021.

Plus, let’s say the market drops 50% this year, but 10 years from today, it’s up 600%.

Would that mean today is really “dangerous”?

Not if you’re 40 and investing for the long-haul with money you won’t need to access anytime soon.

On the other hand, if you’re 72 and drawing down your nest egg to fund your retirement without much financial breathing room, a huge drop could be a disaster.

But looking at today’s market through the specifics of your unique financial reality ties in with the umbrella plan we’ll discuss later in this Digest. Before we get there, let’s start with some objective truths about today’s market.

As we’ve highlighted here in the Digest, today’s price-to-earnings ratio for the S&P 500 is at highly-elevated levels. It has only been higher twice since 1870, as you can see below.

For greater context, the long-term average is 15.88. That puts today’s reading, nearly 39, 144% higher than average.

Now, a lot of bearish commentary stops here — “Beware because the market is overvalued!”

But let’s go deeper than that. Let’s discuss why buying at such elevated levels isn’t always the best idea.

To do this, let’s shift from analyzing the price-to-earnings ratio to its cousin, the cyclically-adjusted-price-to-earnings ratio, often called the CAPE ratio.

The difference between a price-to-earnings ratio and the CAPE ratio is that CAPE uses earnings stretched over a 10-year period. This is done to smooth out business-cycle fluctuations.

The CAPE ratio’s current level is 34.95, making it the second most expensive market since 1870, behind only the Dot Com bubble …

Now, markets tend to revert to the mean over time. So, logic would suggest that a stock market with an above-average CAPE value today would eventually see its value fall.

Meanwhile, logically, a stock market with a below-average CAPE value today is likely to eventually see its value rise.

The more extreme the starting CAPE value (either high or low), the more pronounced that respective “rising” or “falling” is.

This shows up in the returns of the S&P 500.

***So, what does history teach us about stock market performance based on different starting levels of the CAPE ratio?

If anyone has the answer, it’s my friend Meb Faber.

Meb is a “quant” investor who helms the investment shop, Cambria. He studies historical market data to create quantitative rules that guide his market decisions.

Below is a chart from Meb. Starting in 1900, it shows initial CAPE values of the S&P 500 and what the ensuing S&P 10-year returns were based on those starting CAPE values.

Dark green represents the cheapest CAPE starting years. Red represents the most expensive.

As you’ll see visually, most of the “green” starting years (low CAPE ratios) end up on the right side of the chart — meaning big, double-digit 10-year returns.

On the flip side, “red” starting years (high CAPE ratios) usually end up on the left side of the chart — meaning low and negative 10-year returns.

Now, remember, today, the CAPE ratio is at 35. The “red” category covers values from “20 to 45.” That means today’s level is deep in this “red” starting-year bucket.

The takeaway is simple …

Odds suggest the broad U.S. stock market will significantly underperform over the next decade.

In a recent Digest, we profiled the warning of legendary investor, Jeremy Grantham, founder of GMO. He famously predicted the 2000 and 2008 downturns and is very bearish on today’s market.

Here’s how he described the relationship between starting valuations and future returns:

The one reality that you can never change is that a higher-priced asset will produce a lower return than a lower-priced asset.

You can’t have your cake and eat it. You can enjoy it now, or you can enjoy it steadily in the distant future, but not both — and the price we pay for having this market go higher and higher is a lower 10-year return from the peak.

Now, let’s be realistic.

Nosebleed valuations today don’t mean a cataclysmic crash tomorrow. You’ve probably heard the famous John Maynard Keynes quote: “The markets can remain irrational longer than you can remain solvent.”

So, couldn’t today’s lofty valuations last for quite a bit longer?

Absolutely. And we hope they do!

In fact, we hope that an economic reopening later this year gooses corporate earnings, taking pressure off these nosebleed valuations without a crash.

But let’s add a new wrinkle that suggests we should consider buying that umbrella, even as we hope for a strong market …

***Investors are beginning to act euphoric and crazy … which is a time-worn sign of a market top

Years ago, I worked with Meb at Cambria, occasionally co-hosting his investment podcast, The Meb Faber Show.

One of our guests was Jason Goepfert, founder of the investing service, SentimenTrader. Jason studies the impact of human psychology on the financial markets, using a series of indicators to give him an idea about where the markets might be going next.

In preparing for our podcast with Jason, Meb and I had a discussion that delved into investor sentiment, fundamental analysis, and bear market crashes. In essence, we were wondering what’s the final prelude to a bear market?

My kneejerk answer was “extremely high stock valuations.”

But as we chatted, it became obvious that nosebleed valuations, in-and-of-themselves can’t be the answer. After all, if investor sentiment and momentum is wildly bullish, then the buying continues. What was “extremely high stock valuations” quickly becomes “absurd, laughable, egregiously-high stock valuations.”

So, investor sentiment trumps stock valuations.

This awareness then focused us back to emotion, and we found ourselves wrestling with one fundamental question:

Is “irrational exuberance” a requirement for a bear market to strike?

The idea is that when investors are irrationally exuberant, that enthusiasm draws practically all investors off the sidelines and into the market. And when everyone is invested, and there’s no one left who’s willing to buy at nosebleed prices, that’s when the bubble bursts.

In our interview with Jason, he wasn’t willing to cede that “yes, irrational exuberance is an absolute requirement for a bear market.” Yet, he agreed it certainly appears to be correlated, and its fingerprints are found on virtually all past big bear markets in one way or another.

Today, we’re seeing signs of irrational exuberance.

Here’s Jason from SentimenTrader yesterday, noting just one example:

In late August and early September, we focused heavily on the actions of options traders, because it seemed to represent a clear and present danger. While markets as a whole held up okay in the aftermath, there were pockets of heavy losses, 10% or more.

The action of these traders seems to once again be triggering a sense of excessive speculation.

Last week, the smallest of options traders, those trading 10 contracts or fewer, picked up their call buying. When we look at the raw number of contracts that small traders are buying, it’s astounding. Parabolic is the only accurate term.

A reasonable person would suggest, “Well, maybe they bought a lot of put options, too.”

It wasn’t the case, though – the net difference between calls and puts bought to open is even more extreme …

 

 

We focus so heavily on small traders because they tend to be the most consistent contrary indicator at extremes, and because they’ve become such a driving force, particularly in the options market.

The buying of call options from the smallest of traders remains near the highest levels ever as a proportion of all option volume.

There’s plenty more anecdotal evidence of investor euphoria and craziness.

From Reuters:

Rob Almeida, a portfolio manager at MFS Investment Management said his 16-year old son was mocked by his friend, who runs an investment club at school, for making a 30% return from a MFS fund last year while they were doubling or tripling their money by investing in stocks via mobile apps.

Meanwhile, ten of the top 20 best performers in the Russell 3,000 have surged by roughly 75% — since just the start of January …

And let’s not forget Signal Advance …

Shares of the U.S. healthcare company recently exploded to $70 from 70 cents in under a week.

And why?

Because Tesla founder Elon Musk had tweeted “use Signal” referencing an unlisted texting app, yet the masses thought he was referencing Signal Advance, the healthcare company …

And though we’re talking about stocks, let’s throw in a bitcoin anecdote just for fun.

Actress Lindsey Lohan recently recorded a paid, promotional video for Bitcoin and Ether. In the 12-second-long video, the actress says:

I’m just here to say that Ethereum is going to $10,000 and Bitcoin is going to $100,000. Enjoy a prosperous 2021 and I hope you all get to drive your lambos to the moon.

To clarify, “lambos” means Lamborghinis (the MSRP of a 2021 “lambo” is about $218,000).

Friends, these stories don’t happen in a normal market.

That’s not to say stocks won’t keep climbing. And there’s a bullish case to be made, though that wasn’t the focus of today’s Digest …

(That bullish case includes fiscal and monetary stimulus like nothing we’ve ever seen before in history … interest rates at zero … a re-hash of the TINA dilemma, “There Is No Alternative” to stocks … and a wave of technological advancements that will result in trillions of dollars of economic growth this decade …)

But you’d be incredibly foolish to ignore these absurdities and not plan for a less-than-perfect market.

***So, with all of this in mind, how big is your umbrella?

Not sure how to answer that?

Here’s your gameplan …

Right now, block off at least an hour on your calendar in the next few days.

When that time comes, sit down and do a thorough review of your overall financial situation.

There are many questions to ask yourself including, but not limited to …

How far away is your retirement date from a time perspective? If retirement is decades away, you may choose to focus on a nearer, major capital expense such as a child’s college tuition, or perhaps a down-payment on a home.

Same question, but now answer from a dollar-perspective. For example, are you 25% away from a comfortably funded retirement? Do you have 10% saved toward a down-payment?

(For some context with retirements, Fidelity suggests the rule of thumb is that a retirement beginning at age 67 will need savings of 10 times your income.)

How much money are you putting toward your goal each month?

Based on your answers, are you on track toward reaching your goal? What ballpark annual return does your portfolio need to generate to get you there given your current portfolio value and how much you’re contributing each month?

Does that return seem reasonable?

Now, what would happen to your plan if your portfolio returns 0% this year? Or drops, say, 35%? 50%?

How badly would that derail your retirement timeline? Your down-payment goal? Is the answer acceptable or unacceptable?

What does this say about how much wiggle room you have in your financial projections?

What does this suggest about how much money you should have exposed to the market today?

Would you sleep better at night selling down some of your positions (not selling “all,” just “some”).

In answering that, look at your portfolio holdings. Are you diversified or highly concentrated in a specific sector? What does your answer suggest about the potential size of your portfolio losses if that sector rolls over?

If you’re up huge in one or two positions, is it time to take some profits off the table to add more balance to your portfolio?

Perhaps most importantly, if the market falls, what’s your plan? Ride it out, or abide by a stop-loss? What would be your specific stop-loss value, and why?

Your answer will tie back to how well you’re tracking toward your financial goals, and how much wiggle room you have.

Today’s Digest is running long, so let’s wrap up.

Investors are making huge returns today. And there’s plenty of reason to believe it will continue in 2021.

But when we don’t study the past, we can’t prepare for the future. And right now, the past is telling us we need to plan for less-ideal market conditions — whether they arrive tomorrow or years into the future.

Either way, whenever they come, you’ll be glad to have your umbrella.

Have a good evening,

Jeff Remsburg