Critical Metrics Signal Market Warnings
Back in March of 2016 I wrote a blog presenting data related to an over-bought market at that time. Today’s post (Part 2) is an update and review of that information. U.S. Equities have not cooled off since March of 2009. The following data from ReSolve Asset Management analysts lays out four reasons why the stock market is over-valued. As investors, we need to pay attention to these long-term indicators. The links below provide quick access to the numerical values backing the high valuation of the current market. These values will slowly change over time so we need to be vigilant as new data becomes available. Most of this information comes from that 2016 post, but with updated figures. Here are the four critical market factors with data from a little over a year ago to what it is today.
Shiller CAPE Ratio: The Shiller CAPE Ratio (Was 25.56 – Now is 29.48) is perhaps the best known of these four market indicators. With a value currently above 29 the CAPE is well above its average of 16 to 17. 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.
Q-Ratio: The Q-Ratio (Was 0.95 – Now is 1.06) 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.
Market Capitalization vs. GNP: This article by Jill Mislinski includes a graph showing the Market Cap vs. GNP (Was 115.2% – Now is 133.2%). 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. At 133% this third indicator is also showing the market is over-valued. As this metric, and any of the other four go higher, the greater the risk to individual investors.
Price Regression To S&P 500 Trend: The fourth indicator (Was 91% – Now is 97%) 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 four 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.
It is not my intention to become a complete “Eor.” Neither does it make sense to hide from the facts. So – what does one do with this information. My recommendation is to use the Kipling spreadsheet with care. Monitor the two key sell rules. Once more, they are as follows.
- Sell if the security is performing below SHY.
- Sell if the security is priced below its 195-Day EMA.
Pay attention to the Position Sizing worksheet found in the Kipling and if risk-averse, set stop limit orders. Based on the above four metrics, it is time to be vigilant and protect capital.
Discover more from ITA Wealth Management
Subscribe to get the latest posts sent to your email.
Lowell,
I don’t know why but all my use of the REDA sheet leaves me with $0 cash position allocation in the positions sizing sheet unlike the earlier Kipling sheet which routinely recommended some cash. I suspect I’m doing something wrong but not sure what it is. I have 3 portfolios to work on today so I’d appreciate any suggestions. Or maybe the market is just that strong over the last few months?
Bob W…
Without more details on your portfolios and the selection criteria you are using it’s difficult to say whether there’s a problem. However, right now it’s quite possible that there’s nothing wrong in the SS and it’s a reflection of market conditions.
However, one simple test you could try is to reduce the Max Trade Position risk to a lower value, say 1%. The impact really depends on how many assets you are including in the portfolio – if you are only including a few assets the “Cash” trigger is more likely to get triggered.
Let me know if this helps.
David
David,
Must be the market I have to go down to 0.5% before the cash window starts showing a recommended cash position. I’m using 12 asset positions in the menu setting. Also max of 5 assets per period evaluation also effects cash position. So I guess using 12 and getting a % representation of most of the assets brings the cash down to 0. In the earlier Kipling SS I tended to use the MAX4 approach. So what do you suggest now if I don’t want %’s for a “bunch” of assets in the final selection and I want the auto page to recommend a cash position?
Bob W.
Bob,
Using max assets to be included in portfolio set to 4 would be consistent with the Max4 approach. In addition, allowing more Offset Portfolios (tranches) will average the allocations over a longer lookback period and tend to increase the number of assets in the “bunch” – so you might want to reduce this lookback period to, say, 5 (x1 day separation =1 week average, x2 day separation = 2 week average etc). With these settings you will probably get 4-6 recommendations and a suggested allocation to cash.
If you want to see more REDA choices you can keep the wider settings and transfer discretionary allocations to the Manual Position Sizing sheet and see the recommended cash allocations there together with risk.
Keep the questions coming if you have more – I’m sure other members will also benefit from this.
David
Bob,
Since you are focusing on the Cash position implies that your primary concern is risk. The calculated “Suggested Portfolio Risk” (cell P10) will always be less than the Max Portfolio Risk (Cell L11) that is determined by the max position risk identified in cell L8. – and assumes that the appropriate stops will be placed.
If we widen stops then risk will increase, if we narrow the stops (through SD Multiplier) we reduce risk and may have to reduce holdings and apportion a fraction to cash. This is how the cash allocation is determined – but, in the end, your focus is probably on the “suggested risk” value. This can be reduced either by reducing the max asset risk (cell L8) and/or tightening the stop (SD Multiplier (cell J14).
Hope this helps
David
Bob,
Thanks for this question – it gives me a new idea for testing 🙂
David
David,
I can see how all these parameters determine the risk and therefore the amount parked in cash. I need to play with various combinations and see what works for me. As usual when one introduces more capability/variables to a SS things get more complicated!
Bob W.