How to handle an elevated overvalued market

One of the most asked questions from our users (most of them are new users) is as follows: 

How do I position my portfolios now that the markets, as you stated, are elevated and overvalued?

This question is especially pertinent now that the stock markets (S&P 500 and Dow Jones Industrial Index, for example) are making new all time high in a seemingly unstoppable fashion. 

As always, we believe a critical part of successful investing is to deal with questions like the above from time to time. Furthermore, we believe the answers will be not only useful to new users or new investments, but also to existing users.

Before we go on to discuss, let’s re-iterate one of the basic principles we adopt here at MyPlanIQ:  in investing, no one can predict markets precisely. The only way one can do is to invest using well tested strategies with strong intuition backing. These strategies have to have high probability to deliver positive expected (or average in statistical sense) returns over times within an acceptable risk level. We have discussed MyPlanIQ’s strategies including  Strategic Asset Allocation  and Tactical Asset Allocation with respect to the above criteria. Interested readers can find these discussions in our newsletter collections or others in our articles section. 

Now, let’s first analyze the current situation. 

Markets can still go higher, maybe a lot

Currently, stock markets are still exhibiting upward momentum, although not entirely uniformly. All of the risk assets (including commodities and emerging market stocks) have positive trend scores at the moment (see 360° Market Overview). 

However, as we stated previously many times (see Market Indicators for example), currently, markets are very overvalued by various long term credible metrics such as Shiller’s CAPE (Cyclically Adjusted Price Earnings) 10 ratio (Price over last 10 years average earnings). Based on Hussman and GMO (see March 10, 2014: Where Are We Now In Valuation And Momentum Phases? for example), US stocks will have 0 to 2% returns in the coming 7 to 10 years.  

So we are now facing a dilemma: in the long term, stocks are overvalued so they will deliver very low returns from this point on. On the other hand, stocks are still showing good momentum upward. 

From probability point of view, it is possible for markets still go higher, maybe a lot. This has been demonstrated from time to time in the past. Bubbles are formed but no one can precisely predict when they will pop. For example, Shiller’s CAPE10 reached (see P Shiller Cyclically Adjusted PE 10 SO SU Stock Market Timing Strategy Weekly) a  ‘significant overvalued’ state (i.e. its current CAPE10 is 1.5 times more than its long term average) in November 2013. However, markets have been relentless and just kept going up. We have seen this movie before in 2007 and 2001. In fact, Shiller CAPE10 was overvalued for a long time (more than 10 years) even before it finally came down to a reasonable value in 2008. 

So whether it is a bubble or not, stocks can still go higher. It is possible. 

But stocks can correct sharply too

However, similarly, stocks can correct sharply from this point on. Not only we are pretty sure there will be another bear market eventually: after 2000-2002 and 2008-2009 bear markets, probably no one will dare or care to make statements like ‘stocks have reached a permanently high plateau’ by Irving Fisher), the correction/next bear market might be just around the corner. 

Also, the magnitude of such a correction can be as high as over 30-50%. This is a possibility and it will happen for sure sometime in the future. 

Subjectively, we believe risk of stock correction is much higher than the continuing stock ascent. However, again, we resort not to counting on our subjective views as they are fickle, emotional as well as no way to test or prove it through historical data or even random data scientifically. 

What to do

So what do we do if we are just a new investor, or an existing one who has been under invested up to now, or we just simply have some new money to invest?

For one, we have advocated Dollar Cost Averaging (DCA) for a while now. What DCA does is to divide the money into several chunks (such as 3 to 5) and then invest each chunk at a preset pace (such as one chunk per month or per quarter). The key here is to solve the timing dilemma just like the one above. However, in addition to DCA, the other important question is: what types of portfolios?

In the following, we outline 6 possible types of portfolios: 

• Strategic Asset Allocation (SAA) DCA
• Tactical Asset Allocation (TAA) DCA
• Use hedge (mutual) funds that adopts strategies to protect a portfolio such as long short funds or market neutral funds. 
• Use hedge portfolios such as Harry Browne Permanent Portfolio or Bridgewater All Weather Portfolio With Risk Parity.
• Or you can go all bonds using a tactical bond upgrade portfolio such as those total return bond fund upgrade portfolios listed on brokerage investor page and wait till a big enough correction to start to align with your target portfolio. 
• Or use a conservative upgrade portfolio such as those listed on brokerage investor page and wait till a big enough correction to start to align with your target portfolio.

Regardless, all of the above have pros and cons. 

Be prepared for a loss or low return

Unfortunately, given the current extreme conditions, all of the 6 types of portfolios are likely to result in a loss or low return in the short term. Investors should be prepared for these outcomes psychologically. 

• SAA DCA: this is the most obvious one when markets undergo a sharp correction. Furthermore, the miserable long term return perspective for stocks makes this solution less attractive, even for the long term. 
• TAA DCA: this can result in a big loss in the short term if a correction starts to develop rapidly. Hopefully, in an intermediate term, other asset classes (such as bonds) might signal a warning and steer a TAA portfolio to reduce risk asset exposure before the correction is in full swing. Offsetting this, however, is that MyPlanIQ TAA uses trend following method, which essentially directs you to purchase ‘hot’ assets such as US stocks. It can correct much harder than other assets when a downturn hits without any warnings (or strength)  from other asset classes. 
• Hedge funds can be good candidates too. However, it is just as hard as in the TAA DCA case:  predicting stock markets accurately in the short term is impossible and error prone. Furthermore,  most hedge mutual funds have had very uneven records: some of them have been overly conservative; some of them have been subject to various implementation errors even though their long term macro views are excellent; some of them take excessive risks (such as leverage) that can result in even bigger swings or losses. Some of the funds we like are
•  HSGFX (Hussman Strategic Growth): even though the fund has suffered tremendously, we believe the fund is near the end of its low point.
•  BPLEX (Robeco Long/Short Eq Inv): this long short fund has an outstanding 10 year and 15 year record. It has a similar volatility (standard deviation) as S&P 500, compared with one third to half of S&P 500 standard deviation for HSGFX. 
•  MFLDX (Marketfield): another good fund. However, it suffers from a year to date loss at the moment. 

The biggest issue to use these funds is to filter out under performers periodically as they can still result in large loss over times. 

• Total return bond funds are good but again, they are just bond portfolios. They will not enable investors to participate the current rally (if there is any remained). If this extended market continues to extend for a good while, investors will feel left out before the eventual correction comes. This can result in psychological anxiety and possible loss of gains. 
• Similarly conservative allocation funds can also help one to navigate through this period. 

Putting all together

So what is our opinion? For one, we do not recommend a pure SAA DCA at the moment. Unless you are sure the money is really for a long term (given the current market conditions, at least for 20 years or more), the portfolio has a miserable long term perspective. However, we do believe putting some portion of money into this kind of portfolios is still making sense. 

In fact, one can adopt a hybrid solution by using a combination of the above portfolios. Here are two possible ways: 

• Uses total return bond portfolios for your Cash to be invested in the DCA. By doing so, you can still make some better returns in the Cash portion while waiting to deploy this cash and it might even allow you to wait a bit longer before deploying into stocks and other risk assets. 
• Similarly, you can invest in a combination of portfolios such as TAA DCA and hedge funds or permanent portfolios together. Again, the ‘safer’ portion of the money can hopefully smooth out your overall investments without totally jeopardizing your capital. 

However, regardless of whatever way you end up using, one should understand that all of them can be subject to bigger loss before getting to a fully invest state or lower return for a while if you are cautious enough. The latter, however, can be hard for many investors as the wait for a correction can be long. A proper combination or mix can alleviate the pain here.

Finally, we would like to remind existing users of the possible loss for any portfolio: it is becoming more likely to have a sharp correction. That is why it is important to adjust your risk exposure to a comfortable level regularly. Or put it other way, right now, it is riskier than other times. 

To summarize, it is psychologically and technically challenging to invest a new portion of money in the current environment. However, better planning and proper trade off can definitely help here.  

Portfolio Reviews

As stock markets are making new highs, it is a good time to review how our most aggressive (i.e. risk profile 0 or they can invest up to 100% in stocks) tactical allocation portfolios have done, compared with S&P 500 (VFINX): 

Portfolio Performance Comparison (as of 5/12/2014): 

See year by year detailed comparison >>

So far, year to date, 4 out of 6 tactical portfolios out performed VFINX.  Among the other two portfolios, it is understandable for Retirement Income ETFs Tactical Asset Allocation Most Aggressive to lag behind as the portfolio invests in dividend paying ETFs that usually do not rise rapidly when general markets are surging. P Momentum Scoring Style ETFs and Treasuries, a portfolio that rotates among US stock style ETFs (such as large growth, small value etc.), suffered from the change of trends recently. This is a normal behavior exhibited by a trend following portfolio.  The other 4 winning portfolios all benefit from strength in other assets such as REITs. 

In the 10 year time frame, however, all of our 6 portfolios have out performed VFINX by some big margins and much lower risk (standard deviation). 

Market Overview

Stocks made record high again today. For now, all risk assets (other than Gold) are ranked higher than cash or bonds. However, even though small cap stocks made a noticeable recovery, we note that they are still far from their all time highs. In fact, Russell 2000, an index for small cap stocks, is still much below the all time high it made on March 4 this year. 

For more detailed asset trend scores, please refer to 360° Market Overview.

We would like to remind our readers that markets are more precarious now than other times in the last 5 years. It is a good time and imperative to adjust to a risk level you are comfortable with right now.  However, recognizing our deficiency to predict the markets, we will stay on course. 

We again copy our position statements (from previous newsletters): 

Our position has not changed: We still maintain our cautious attitude to the recent stock market strength. Again, we have not seen any meaningful or substantial structural change in the U.S., European and emerging market economies. However, we will let markets sort this out and will try to take advantage over its irrational behavior if it is possible. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot. 

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