September 5, 2016: Overvalued Markets And Long Term Timing Strategies

Sep 6, 2016 | Asset-Allocation, Bonds, Economy, Feature, Gold, Headline, Income, Investments, IRA, Markets, Mutual-Funds, Newsletter, Retirement

Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

For regular SAA and TAA portfolios, the next re-balance will be on Monday, September 19, 2016. You can also find the re-balance calendar for 2016 on ‘Dashboard‘ page once you log in.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Please note that we now list the next re-balance date on every portfolio page.

Overvalued Markets and Long Term Timing Strategies

Let’s first look at August market performance:

While rate sensitive assets including long term bonds, gold and REITs all had some loss, emerging market stocks (Vanguard emerging market stock index VEIEX) gained most (almost 2%). Other stock assets including international stocks (VGTSX) and US stocks (VFINX) were also positive. This happened in a backdrop where US stocks were near all time high.

Stocks in August were also in one of the least volatile periods in history, S&P 500 index was in a tight range. It’s also one of those summers in which stocks had a reasonable gain: S&P 500 gained about 4.6% since the end of May. On the other hand, users who were concerned about stock weakness in the summer (so called ‘sell in May and go away’ seasonality) didn’t fare badly either: bonds have also had a respectable gain: 2.4% since 5/31/2016. If, instead of investing in bond index such as BND or VBMFX, investors put their money to one of our total return bond fund portfolios such as P_46880 (Schwab Total Return Bond), they would have gained 4.4% since the end of May, matching S&P 500’s. 

Stocks continue to be significantly overvalued

Stocks are stubbornly overvalued. Based on Market Indicators: 

  • Buffet Stock Market Indicator: On Sep 2, 2016, the ratio of the total stock market capitalization to GNP is 152%. 
  • Shiller CAPE10: On Sep 2, 2016, the ratio of Real Price to the average of last 10 year Real Earnings(CAPE10)(28.12) to its long term average (16.69) is 1.68. 

In general, stocks are significantly overvalued (50% and up) based on popular long term valuation metrics. Interested readers can also look at other metrics from dshort.com. 

Long term timing strategies

Interestingly, year to date, the long term timing based portfolios are doing as well as S&P 500: 

Portfolio Performance Comparison (as of 9/2/2016)
Ticker/Portfolio Name YTD
Return**		 1Yr AR 3Yr AR 5Yr AR 10Yr AR 10Yr Sharpe
P Warren Buffett Total Stock Market Valuation to GNP Ratio SO SU Weekly Strategy Total Return Bond Funds As Cash 8.1% 7.6% 4.8% 11.2% 11.9% 0.88
P Shiller Cyclically Adjusted PE 10 SO SU Stock Market Timing Strategy Weekly Total Return Bond Funds As Cash 8.1% 7.6% 7.7% 12.6% 12.6% 0.91
VFINX (Vanguard 500 Index Investor) 8.2% 14.2% 12.3% 15.5% 7.4% 0.33

These portfolios were first mentioned in April 13, 2015: Total Return Bond Funds As Smart Cash. They are listed on Advanced Strategies. These portfolios have done so well, thanks to the ultra low interest rates across all bond spectrums (long bonds, corporate bonds and even municipal bonds). 

What if a bear market strikes?

Several users have voiced concerns about the current market environment: not only stocks are overvalued, bonds are also at a historically high level (or their yields are historically low). So if a substantial stock market downturn does strike in the near future, what will happen? Traditionally, when stocks are in a bear market, bonds tend to hold up their value or even have some gain. That would benefit the above long term timing based portfolios as they are now in some total return bond funds. However, is this time different?

Let’s answer this question by analyzing two possible scenarios:

  1. A Fed interest rate hike induced bear market: in this case, because of the concern that rising interest rates could derail economy growth and even possibly stoke up inflation, investors will exit not only stocks, but they will also dump bonds, especially long term and high yield bonds. Fortunately, for portfolios that have invest in one of our total return bond fund portfolios as a cash substitute, these portfolios will rotate out of bond funds that are sensitive to both interest rates and credit worthiness. As a last resort, they will exit bond funds all together and instead invest in cash. 
  2. A deflation induced bear market: in this case, similar to those in 2000 and 2008, bonds, especially government bonds will hold up really well, still preserving the normal stock and bond negative correlation. Portfolios that invest in a total return bond fund should not have problem to switch to a fund that has invested in high quality bonds. 

Regardless of the scenarios, there will be some pains in a portfolio because of the turn of markets (trend change). But such a short term dislocation is a price one has to pay, especially for a trend following portfolio such as our Tactical Asset Allocation(TAA) portfolio or our total return bond fund portfolio. Unfortunately, this time around, such a short term pain has become more likely because of scenario 1 or the current ultra low interest rates. 

To summarize, both stocks and bonds continue to be at an extended elevated level. It’s increasingly possible to create some short term gyration for strategic, tactical, strategic or even long term timing portfolios (which have now totally avoided stocks and invest in bonds). Investors should adopt a more vigilant attitude and prepare for the possible event (and pain). 

Market Overview

As can be seen in the previous chart, US REITs have weakened for the past one month, mostly due to their high prices and the concern of upcoming interest rate hike. Similarly, gold has also retreated a bit. Depending on what angle you are looking, one can say markets are waiting for another shoe to drop or waiting for earnings to recover (or resume growth) in the next quarters. Unfortunately, for many value investors, they are usually early in predicting a market downturn. On the other hand, as markets continue to ascend, risk will only become bigger. As always, staying on a course that has been well designed and vetted will serve investors well. 

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

We would like to remind our readers that since the financial crisis in 2008-2009, we have not seen substantial structural change in the U.S., European and emerging market economies. Economies have heavily relied on low interest debts. Capital might be misallocated to unproductive investments and consumption. U.S. stock valuation is at a historically high level. It is thus not a good time to take excessive risk. However, we remain optimistic on U.S. economy in the long term and believe much better investment opportunities will arise in the future. 

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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