Be Fearful When Others Are Greedy and Greedy When Others Are Fearful (Warren Buffett)
If you are an individual, collar your portfolio like the pros collar their portfolios after this over 300% stock market gain. Don’t be too avaricious and get caught long equities when the bottom drops out of the stock market again as it has as recently as October 1, 2018. Hedge your stocks and protect your gains after the longest bull market in US history. The recent market waterfall decline through December lopped a quick 520 points (20%) off the S&P and a near 5000 points off the Dow from its highs before recovering 18% when the Federal Reserve panicked and backed off its policy of raising interest rates and reducing the Fed balance sheet reduction (Quantitative Tightening). The market didn’t rally on favorable corporate revenue or earnings prospects. It didn’t rally on a better US growth or GDP outlook. It rallied on continued easy money and monetary stimulus. The ECB and China also backed off normalizing their interest rates, apparently all fearing causing a recession. Is this action a harbinger of the next cyclical bear market? Is this waterfall decline and Fed backpedaling a warning of what is to come? Bryce Coward Research has cataloged all of the 20 uninterrupted 15% or more waterfall declines like this in the post-war period and documented what has happened afterward:
- The average counter-trend rally following a 15% waterfall decline is 11.9% and it takes place over 21 trading days on average.
- Waterfall declines of at least 15% have only taken place in bear markets.
- In 16 of 19 instances (excluding the decline we just witnessed), a recession was associated with the bear markets.
For the past 20 years, the Federal Reserve has been producing booms then busts in the economy. By artificially suppressing interest rates for long stretches, The Fed has unwittingly produced two stock market bubbles and a real estate bubble. They all ended in busts. The interest rate suppression for the past 8 years has been the most severe, the longest and has now produced the greatest stock market (and bond market) bubble of all time. This next bust looks commensurately like it might be the biggest one ever. Is your portfolio recession proof?
The same warning signs that appear before every equity bear market are evident now. The stock market has never been this overvalued. Let me repeat that. The stock market has never been this overvalued. For example, the median price / earnings ratio for the stocks on the NYSE in late 2018 reached a record high (exceeding the peaks in 1929, 2000 and 2007). Moreover, the price/sales ratio on the S&P slightly exceeded the 2000 market peak’s all-time high while the median price/sales ratio is two times the 2000 peak. Even Warren Buffett’s favorite overvaluation indicator (stock market capitalization / GDP) is flashing peril. It likewise just topped its previous apex from year 2000, from which the stock market dropped 50% and the NASDAQ tumbled 80%. The Buffett indicator recently hit 140% – up from 57% at the depth of the 2009 recession. (Now that was the time to buy stocks!) At 140% reading, the capitalization of the US stock market is 140% of US GDP. A reading over 100% (it topped out at 105% at the market peak in 2007) flashes a warning sign. At a reading of 140%, the red lights and sirens are both on. Overvaluation can extend the perception of good future earnings only so far. You can grow but you can’t grow out of your own skin.
The S&P was down 6% last year. After the longest US bull market in history, at this overvalued juncture and after a 300% stock market gain, what would you hope to gain in 2019 by still being long equities? 5%? 7%? The market has rallied 16% so far this year on optimism from continued low interest rates and a China trade deal despite lower 2019 projections of US (and world) growth, lower GDP and lower corporate earnings. I would think that to not take at least some profits after this massive run, if it is not the ultimate expression of greed or stock market masochism, then it certainly is a selfish disregard for the well being of your beneficiaries or ultimate heirs.
It is not what you make, it is what you keep.
Why not hedge your portfolio now, take a pass on the next bear market and get back in 50% lower when there is real value. Buffett’s billionaire partner, Charlie Munger, always preaches patience; patience to wait for value to exist; patience for months or even years for the right stock at the right price. Remember, the amount of the gain you make from an investment is directly dependent on the price you pay. It is not what you buy, it is what you pay. Meanwhile, the Federal Reserve and world Central Banks are still trying to keep this vastly overpriced stock market elevated with stimulus talk. The analysts (salesmen) on CNBC are likewise trying to get you to bite at expensive equities while corporate America is lowering its future earnings and the US and world economies are lowering their growth prospects and GDP numbers.
In addition to over optimistic income statements, corporate balance sheets are also top heavy. Corporations (and consumers) have loaded up with considerably more debt than at previous market tops. As profits slide and interest rates rise, corporate treasurers might find it difficult to not only make their current interest payments but also refinance at higher rates. We don’t know the exact catalyst that will end this bull market but we do know it will end. The last three similar stock market bubbles that exhibited these blazing warning signs all ended in crashes.
It is not what you buy but what you pay
The S&P is historically overpriced now as the Price / Sales ratio reflects an all-time bubble high valuation. This indicator is similar to the “Buffett ratio” in that the average stock price today is much too elevated in relation to the underlying sales (and future sales) of that company.
If this is the start of another, cyclical bear market, we have a long way to go before it bottoms. It is not too late to protect your gains now with near free portfolio insurance. It is a “heads I win, tails nothing happens” strategy. Why put yourself into a position of waiting another 5-6 years for the stock market to come back to merely recoup your losses after the bear market has ended? Why be greedy? Why not lock in the profits in some or all of the appreciated stocks or holdings in your portfolio? Why not take some risk off the table after a stock market that has risen four fold (some stocks even more) since March, 2009. You can hedge your portfolio while keeping your dividend income and without paying hefty capital gains taxes on your big winners with an option collar strategy. Hedging your winners on your terms at this lofty market level, especially if you are near retirement, is certainly better than watching your profits erode and perhaps selling later when nice gains turn into losses and become too painful to stand.
Asked how he got so rich in the stock market, Baron Rothschild said, “I will tell you my secret if you wish. I always sell too soon.”
Many investors overlook the fact that stock market cycles echo the upturns and downturns of economic cycles. Since US companies are a direct reflection of the economy over time their stocks will track the economy with a 100% correlation. It has been over 9 3/4 years since the last equity bear market (recession)- the longest bull market (recovery) in US history. We are overdue for a correction. Most investors forgot that the 2008-2009 stock market decline saw 12 years of gains disappear. How many years of profits are you willing to sacrifice?
Stock markets rise like an escalator, but fall like an elevator. Once an investor realizes that the market peak is in, it is too late. The recent sell-off lopped off 20% from the peak highs before recovering. FAANG and NASDAQ stocks suffered more. In a January 10, 2019 Deloitte survey of 147 CFOs of large corporations from the US, Canada and Mexico, more than half of the CFOs predict a recession next year. Remember, the stock market is a forecasting tool of the economy. By the time the country is in a slowdown or recession the stock market will have already sold off and entered a bear market. As the economy weakens there will be more investors rushing to the elevator. Not everyone will be able to sell their stocks at the price they had envisioned. Take some market exposure off the table. Do not forget the Wall Street adage: “the public buys the most at the top and the least at the bottom.”
If you are an investment firm, be a hero. If you are an RIA, step up to the plate. Accept your fiduciary responsibility and protect your clients’ gains after this lengthy, record 9 3/4 year run and over four fold increase. Don’t let your customers’ profits and retirement savings slip away due to shortsightedness. Do you think the stock market owes you an automatic 7% return in 2019 after a record 300% increase over the past decade? Market averages always revert to the mean. What is your greatest risk, to forgo a 5-10% advance or experience a 50% downturn? Conventional wisdom is always bullish at the top of every market cycle. What is your risk tolerance?
The last two bear markets extracted 50% and 58%, respectively from investors gains, as the chart above illustrates: March 2000 to October 2002, S&P 500 high: 1553 – Low: 776, S&P 500 Loss: 50%, Duration: 31 months; October 2007 to March 2009, S&P 500 high: 1577- Low: 666, S&P 500 loss: 58%, Duration: 17 months
“Advisors are continually focused on adjusting client portfolios for maximum return while also managing risk. But is the same true for how they manage their own ‘wellness’ portfolio? In late 2017, FlexShares surveyed more than 700 financial advisors on their own perceived wellness. They were queried across a variety of criteria. The survey reveals that advisors are stressed – 25% more stressed than the average American.” Now that the stock market is beginning to correct as general interest rates rise and the Central Banks curtail their QE (Quantatative Easing), advisor and PM’s stress levels are rising even more. Advisors are responsible for the safekeeping the millions of dollars of gains that their clients have accrued. Their quest should be one of preservation of capital rather than further gains.
“Barron’s” magazine has often suggested the use of option collars. Those articles are on this website in the “Articles” section. A Zero Cost Option Strategy can provide a free (except for commissions) downside insurance for your portfolio. Why take the risk of a totally uninsured portfolio at what appears to be another cyclical stock market top? You can hedge your portfolio, keep your stocks’ dividend income and avoid capital gains tax. As “Barron’s” magazine states “This collar strategy is almost too good to be true.”
“When did Noah build the Ark, Gladys? Before the rain, before the rain.” —Nathan Muir (Robert Redford), in Spygame.
Is it different this time? Will there never be an economic slowdown or bear market again? The market indexes are still near their highest valuation ever. After 2000 years of economic history did Fed chairman Ponce de Bernank discover the economic fountain of youth? Can we just borrow and spend our way to prosperity? Can the world Central Banks simply suppress interest rates and print trillions of their fiat currency to support the world bond and stock markets without a disastrous consequence? There have been 19 recessions since the formation of the Federal Reserve in 1913. They have a terrible track record of “controlling” the economy. Central Planners always have. Can it possibly be that that the Fed’s manipulation and suppression of interest rates create financial bubbles that, when pricked,cause longer and deeper recessions than the ones they were trying to prevent? You can’t fool Mother Nature.
Furthermore, what will happen to the stock and bond markets when the Fed and other Central Banks not only stop but also reverse their massive $16 trillion liquidity stimulus (Quantitative Easing) and begin to taper their stimulus? (see chart below). Are you prepared to accept lower stock valuations? How can the stock market go up on tremendous stimulus yet still go up when that stimulus is withdrawn (no more QE) and reversed (QT or Quantitative Tightening)?