A little over a year ago I wrote a blog laying out four indicators that point to an over-valued U.S. Equities market. Today those indicators are updated and most continue to rise. If the market was over-valued a year ago, it is even more so today. However, there are indications the rate of stock market growth is slowing. What might be causing this change and is it a healthy change?
Historically, the market has grown at a rate of 8.5% since 1900 if inflation and dividends are part of the calculation. Since the beginning of this year the S&P 500 has grown a little below 6.0% or not quite up to the historical average. Over the past year several indexes marked new highs and we have been in a sustained bull market since March of 2009. This is the longest bull market since WWII. How long can this last and are there any signals we should watch that might help identify an exhausted bull? Below are a few markers to watch.
Overall, the trends toward an over-valued market continue. As investors, how do we behave or manage portfolios in this environment? It does not seem appropriate to run for the Cash hill, nor does it appear to be a time to back up the truck and load up with equity ETFs. The Dual Momentum model is moving assets over to income generators. That is one approach. Another is to set Trailing Stop Loss Orders under current holdings as the various portfolios come up for review. This is a second cautionary approach. I’ve been following recommendations that come out of the Kipling or what we once called the Tranche Momentum model and now referred to as the LRPC or BHS model. This model is also moving assets toward income oriented securities. Later today I will provide an example of how to use dividend or high yield securities to build a portfolio.
Below are factors that merit special attention when the market is as high as it is today. Factors three (3) through six (6) are updated from information posted a little over a year ago.
1. Rising interest rates: When the economy heats up and inflation raises its ugly head, the Federal Reserve raises interest rates to slow growth. That is happening now and we expect to see higher interest rates in the future. While rising interest rates cost businesses more to borrow, the corporation tax cuts provide them with plenty of cash to expand. I don’t see a few more minor interest increases slowing this bull market. I could be wrong on this point.
2. Inverted yield curve: I wrote about the yield curve on June 28, 2018. Below are the updated figures. Note the delta increases. These three ETFs can be used to give a heads up notice of current yields. Expect to see the SHY yield increase as the Feds raise interest rates. Since last updated, the short-term interest rate (SHY) is increasing at a faster rate than the long-term (TLT) interest rate. This does not bode well for continuation of the bull market.
- SHY – 1 – 3 Yr Treasury Bond (1.31%) SHY is now 1.55%. Δ = 0.24%
- IEF – 7 – 10 Yr Treasury Bond (2.02%) IEF is now 2.17% Δ = 0.15%
- TLT – 20+ Yr Treasury Bond (2.62%) TLT is now 2.78% Δ = 0.16%
Based on one article I read, the inverted yield curve predicted the last seven recessions.
3. Shiller CAPE Ratio: The Shiller CAPE Ratio is perhaps the best known of these four market indicators. With a value currently above 31 the CAPE is well above its average of 16 to 17, but not close to the 1999-2001 high. The tech bubble pushed this indicator out of sight. Note from the graph what a buying opportunity the market was in 1982. Many of us were able to take advantage of the low market value as the DJI was around 780 in August of 1982. The Shiller CAPE is one long-range indicator to watch. If the above link does not work, Google the term.
4. Q-Ratio: The Q-Ratio is the measure of the market value of a company divided by its replacement cost. How expensive are stocks relative to the replacement value of the corporate assets. Look at the level in 1982. Here is another definition of the Q-Ratio.
5. Market Capitalization vs. GNP: This article by Jill Mislinski includes a graph showing the Market Cap vs. GNP. This is one of Warren Buffett’s favorite broad market indicators. Advisor Perspectives is one of my highly ranked Bookmarks and you will find it listed in the right-hand side bar.
6. Price Regression To S&P 500 Trend: The fourth indicator examines the pricing trend vs. the S&P 500 trend. Check the graph in this link showing the long-term price trend of the S&P 500. Note the 1966 and 1982 dates as well as the more recent inflection points. This fourth indicator is a reflection of what is going on in the prior three indicators.
If we take the above six indicators as warning signals and combine it with the Nasty Mathematics of Volatility, we need to be on constant guard to protect capital as we devote more attention to portfolio risk. Take time to think through the information in this blog if you have not previously done so. Again, much of this blog was an update from prior blogs on this same subject.