What To Do In Overvalued Stock Markets

As stock markets underwent a mini-correction and now are back to their up trend, more and more average investors are becoming complacent: the persistent upward stock prices in the last 5 years almost make the concept and method of investing in stock markets a no brainer: you just need to put your money in US stocks, being high tech stocks or small cap stocks, you will do well. 

Five years are a long time for a person! It is hard to demand people to have a long term memory and even you have one, the distant past is becoming more and more blurry. 

However, 5 years is a really short period, or have very limited number of sample points in a statistical sense. 

Furthermore, for those of us who have experienced the last two bear markets, we remember all too well how violent markets can become. 

To make the matter worse, currently stock markets are overvalued by many long term metrics. For example, as of 8/8/2014, all of the three long term metrics we follow are overvalued: 

• Buffet Stock Market Indicator:The ratio of the total stock market capitalization to GNP is 135%. US stock market is Overvalued. 
• Shiller CAPE10: The ratio of Real Price to the average of last 10 year Real Earnings (CAPE10)(26.25) to its long term average (16.55) is 1.59. US stock market is 59% Overvalued.
• Hussman Peak PE: The ratio of Real Price to the average of last 10 year Peak Real Earnings(18.78) to its long term average (12) is 1.56. US stock market is 56% Overvalued. 

See  Market Indicators page for more details.

Regarding what to do in such an overvalued market, you can find many ideas (noises?) in financial media. Some calls for caution (but what to do?) and some dismiss this out right. 

We discussed this issue in our previous newsletter:

• November 11, 2013: Tactical Asset Allocation In Overvalued Stock Markets

In this newsletter, we will revisit this issue and the  method. 

The Cons of Strategic (Buy and Hold) and Out of Markets

Let’s look at this S&P long term return chart again: 

It is clear that when markets correct from its long term 6.5% return trend line, it can go under a lot. That is evident in 2001-2002 and 2008-2009.

So a Strategic Asset Allocation portfolio can suffer from a large loss in a bear market. However, as long as investors have a proper preparation psychologically and as long as the capital in such portfolios is for a long term purpose, investors can ride such bear markets out, even though that can be a long time to come. For example, at the moment, it is estimated that S&P 500 (or US stocks in general) is going to deliver an annual 2% or so return in the coming decade. This will highly likely come with some serious bear markets in between. 

However, simply getting out of stock markets when they are overvalued based on the above long term metrics can be extremely challenging as markets can be persistently in such an elevated overvalued state for a long time. For example, Shiller Cyclically Adjusted PE 10 (CAPE 10) stayed above  1.5 times its long term average from 1995 to 2009, a period of 14 years! It is not feasible for a normal investor to be out of stock markets for such a long time, let alone missing out a big market rise!

We thus introduced a method in November 11, 2013: Tactical Asset Allocation In Overvalued Stock Markets that calls for switching to our Tactical Asset Allocation strategy when markets are overvalued. 

Revisit switching between SAA and TAA when markets are over or under valued

In the previous method, the algorithm does as follows: 

IF markets are over valued (such as more than 1.5 times CAPE 10 long term average) then switch to a tactical portfolio

ELSE buy S&P 500  index fund (proxy to a strategic portfolio)

The problem with the above is that it is possible that once markets are falling back to non significant overvalued state such as 1.3 times its long term average, the strategy will switch to the strategic, which can be subject to significant loss subsequently. 

For example, in the portfolio P Shiller Cyclically Adjusted PE 10 SO SU Tactical Strategic Switch Monthly 1.5x, the portfolio switched to VFINX (Vanguard 500 index fund, an S&P 500 index fund) on 1/31/2008, just in time to be subject to a big fall. 

We can modify the strategy as follows: 

IF Shiller CAPE10 > 1.5x CAPE10 Long Term Average, switch to tactical ( P Relative Strength Trend Following Six Assets). 

ELSE 

IF Shiller CAPE10 < 0.83x CAPE10 Long Term Average, buy VFINX (S&P 500) (switch to strategic)

ELSE hold 

What the above does is to make sure once stock markets enter a significant overvalued state, it will not buy and hold stocks until it is significantly undervalued (in this case 0.83 times CAPE10 average). Similarly, it will not switch to a tactical strategy unless it has become significantly overvalued. 

The following table shows the performance of the modified portfolios, back tested from 1991 (a 23 year period):

Portfolio Performance Comparison (as of 8/11/2014): 

See the full detailed comparison >>

This compares with  the portfolios mentioned in the previous newsletter: 

Portfolio Performance Comparison (as of 8/11/2014): 

See the full detailed comparison >>

We see a significant improvement in both the returns and the maximum drawdown (to see maximum drawdown data, click on the above detailed links). 

To summarize: 

It is possible to switch between both  SAA (Strategic Asset Allocation) and TAA (Tactical Asset Allocation) to cope with significantly overvalued (and to take advantage of significantly undervalued) stock markets in a more effective way. As stock markets are significantly overvalued at the moment, it can be beneficial to pay attention to the tactical strategy. 

However, regardless of which way investors choose to pursue, it is important to understand both pros and cons of these strategies. For this, we refer readers to 

• July 29, 2013: Strategic Asset Allocation: The Good, The Bad And The Ugly

• July 22, 2013: Tactical Asset Allocation: The Good, The Bad And The Ugly

Market Overview

Stock markets are recovering from a mini-crash in last week. At the moment, some damages such as small cap stock weakness and high yield bond weakness are somewhat repaired (not completely). Investors are clearly looking for rotating to other relatively undervalued assets such as emerging market stocks. It might turn out that markets can sustain for a while by switching to other relatively low valued assets. However, as we admit that we don’t have a crystal ball for the future, we will stick to the strategies we choose. 

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. 

Latest Articles

• August 4, 2014: Is This The Peak Or Correction?
• July 28, 2014: Stock Musings
• July 21, 2014: Permanent Portfolios & Four Pillar Foundation Based Framework
• July 14, 2014: Composite Portfolios Review
• July 7, 2014: Portfolio Behavior During Market Corrections
• June 30, 2014: Half Year Brokerage ETF and Mutual Fund Portfolios Review
• June 23, 2014: Newsletter Collection Update
• June 16, 2014: There Are Always Lottery Winners
• June 9, 2014: The Arithmetic of Investment Mistakes
• June 2, 2014: Tips On Portfolio Rebalance
• May 26, 2014: In Praise Of Low Cost Core Asset Class Based Portfolios
• May 19, 2014: Consistency, The Most Important Edge In Investing: Strategic Case
• May 12, 2014: How To Handle An Elevated Overvalued Market
• May 5, 2014: Asset Allocation Funds Review
• April 28, 2014: Now The Economy Backs To The ‘Old Normal’, Should Our Investments Too?
• April 21, 2014: Total Return Bond Investing In The Current Market Environment

Enjoy Newsletter

How can we improve this newsletter? Please take our survey 

–Thanks to those who have already contributed — we appreciate it.

RSS Feed