Attempting to time the market has proven to be a futile exercise for many investors causing them to buy high and sell low ultimately reducing their returns significantly. For patient and disciplined long term investors market fluctuates mean very little. They purchase shares of a company for a price they have determined to be fair value or even below fair value. What Mr. Market is offering to buy their ownership position in their companies is meaningless as they know they paid a fair price and their ownership position will be worth significantly more in the distant future.
With that said, many investors prefer to be more active and dynamically manage their portfolios with the goal of minimizing short to mid-term losses or even profiting from turbulent markets. Investors have been successful at each approach to managing their portfolios and no matter if you choose a dynamic or static portfolio the most important factor is to stay disciplined.
This article provides fundamental analysis for the more enterprising investor to show that the market is currently overvalued and provides a number of investment considerations to hedge against a stock market decline and for those with a higher risk tolerance to profit.
While the chart above does not scream the market is overvalued as it was in the late 90's and 2008-2009, at the time of writing this article the current PE ratio of the S&P 500 was 18.87. When compared with the mean of 15.5 and the median of 14.51 one can deduce that the market is currently 21.7% and 30.0% above its historical averages as measured by the PE ratio.
In plain terms, the PE ratio is simply a measure of investors' expectations of future earnings growth. The higher the multiple indicates that higher earnings growth is anticipated or even expected. The higher the expectations, the more likely it becomes that those expectations will not be met and promptly followed by declines in market value. With expectations over 20% of historical averages the contrarian investor may deem it time to go against the current sentiment in the market.
Cyclically Adjusted P/E Ratio
The cyclically adjusted PE ration is commonly known as the Shiller PE due to its creation by economist Robert Shiller. The ratio is computed by taking the current price and dividing by the average inflation-adjusted earnings from the previous 10 years. With corporate earnings being so volatile when looked at on an annual based, using 10 years of earnings allows movements in price to take into account market cycles.
The current Shiller PE ratio of 23.71 is 43.9% above the historical mean of 16.48 and 49.2% above the historical median of 15.89. With a Shiller PE ratio between 23 and 24 the historical average annualized total return of the S&P 500 for the following 5 years is approximately 5%. While a 5% annualized return would not be devastating to one's portfolio it is significantly below the 8.92% compound annual growth rate of the S&P 500, including dividends, since 1871 and implies that better returns may be found elsewhere.
Corp Profits as a Percentage of GDP
As evidenced by the graph above, corporate profits as a percentage of GDP is at an all time high. The historical average is 6% while we are currently significantly above that at over 10%. What this shows is that companies have been experiencing rising and unsustainably high profit margins as wages have hit historic lows. Below are three quotes from famed investors on profits as a percentage of GDP:
"In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there's a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems--and in my view a major reslicing of the pie just isn't going to happen."
Warren Buffett, Mr. Buffett on the Stock Market (November 1999)
"Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly."
Jeremy Grantham, The Little Book of Sideways Markets (2006)
"…elevated profit margins are also strongly mean-reverting over the economic cycle. In general, elevated profit margins are associated with weak profit growth over the following 4-year period. The historical norm for corporate profits is about 6% of GDP. The present level is about 70% above that, and can be expected to be followed by a contraction in corporate profits over the coming 4-year period, at a roughly 12% annual rate. This will be a surprise. It should not be a surprise."
John Hussman, Two Myths and a Legend (March 2013)
Based on this, one can gather that corporate profits as percent of GDP can't grow forever or they would overtake everything else. The tendency is for profits as percent of GDP to revert the mean of approximately 6% due to the cycles of the economy. The persistently high unemployment rate has enabled corporations to expand profit margins to the elevated levels they have experienced. Currently, corporations have pricing power of wages due to the excess supply in the labor market thus allowing profit margins to rise. Another factor to take into consideration is that when margins are high new competition sees this as a positive market to enter ultimately creating increased competition.
Investment Considerations for an Overvalued Market
Cash - The easiest option is cash. Some investors may choose to simply reduce or liquidate their equity positions and keep a portion of their portfolio in cash, waiting for the stock market to become fairly priced and reinstate their equity position at a lower cost and higher yield. While this option reduces your short term risk, if you are looking to profit from a stock market decline this is not your option.
Bonds - One of the more popular and well known options is investing in bonds. This is due to the prices of both securities being inversely correlated, when one rises the other falls and vice versa. Some examples of options to increase or initiate a position in bonds, respecting rising interest rates, are the Vanguard Short-Term Bond Fund (BSV) and the iShares Short Treasury Bond ETF (SHV). If one is looking for a higher yield, speculative-grade bonds have proved useful when it comes to balancing rate risk and yield. One example of this type of fund is the iShares iBoxx USD High Yield Corporate Bond ETF (HYG) which has held up better than Treasury and corporate bond ETFs during the recent bond market volatility.
Inverse ETFs - Another option that is becoming more popular is inverse ETFs. As their name implies these funds seek to provide returns opposite of the underlying index. For example if the S&P 500 loses 10% these funds are expected to gain 10% before fees. These funds represent another simple way for investors to hedge their equities positions and even profit from a market decline. One such fund is the ProShares Short S&P 500 fund (SH). Additionally, inverse ETFs also come leveraged such as the ProShares UltraShort S&P 500 which provides -2x exposure to the performance of the S&P 500 and the ProShares UltraPro Short S&P 500(SPXU) offering -3x leverage.
One detail about these funds that should be noted is that they are designed to be day-traded, not held as investments. Due to the rolling of the derivatives contracts they hold there is a natural decay of the money invested and this effect is magnified in the leveraged funds.
Put Options - Options are another viable option to not only hedge your equity position but also profit in the case of a declining stock market. With the increasing popularity of ETFs it is easier to buy and sell options for virtually any market or sector. For example you can buy a put option on the SPDR S&P 500ETF Trust (SPY), which the investor would profit from a decline in the S&P 500. Utilizing options is a more risky option however. If the stock market continues to rise you risk losing 100% of your initial investment. However, if the stock market declines you have leveraged exposure with minimal upfront capital required. Bull markets tend to last longer than anyone thinks and you can never know when a correction will occur making longer dated options a good choice.
Buy Volatility - The higher stock prices go the lower volatility becomes typically. A depressed VIX can be interpreted as a lack of fear in the market and is used as contrarian sell signal. The CBOE S&P500 Volatility Index (VIX) as of writing this article is 15.88, 28.3% lower than its historical average of 20.38. One option to profit from an increase in the VIX index is the ProShares VIX Trust II (VIXY). If you want a leveraged fund you can look at the VelocityShares Daily 2x VIX Short Term ETN (TVIX).
Much like the leveraged and inverse funds these are designed to be day-traded, not held as investments and your investment will decay with time.
Currencies - Safe haven currencies are generally defined as an asset that is safe and secure from increased volatility and have the potential to appreciate when risk sentiment is under pressure. According to Goldman Sachs, safe haven currencies have historically been those that are associated with countries that have account surpluses, are a global net creditor, have low inflation, and are a commodity exporter. The safe haven currencies remain the US Dollar, Japanese Yen and the Swiss Franc. Again ETFs are the best way to play this with either the CurrencyShares Japanese Yen Trust (FXY) or the CurrencyShares Swiss Franc Trust (FXF).
Precious Metals - Precious metals, gold, silver, platinum and palladium are often thought of as offering safe haven protection during turbulent times specifically fiat currency crises which includes stock market declines, burgeoning national debt and inflation. Id the returns on equities do not reflect the inherent risk the demand for alternative investments such as gold increases. While buying gold/silver bars or coins is the best option, there are also exchange traded alternatives, specifically SPDR Gold Trust (GLD) or iShares Silver Trust (SLV).
The Bottom Line
There is no silver bullet for determining if the stock market is overvalued and for many investors it is of little concern. Above I have presented 3 charts that signal the market is currently overvalued. As previously mentioned bull markets tend to last longer and go higher than most expect and these metrics are no reason to sell all stocks and sit in cash or buy leveraged ETFs with the hope of becoming an overnight millionaire. It is meant to encourage investors to revisit their portfolios and their diversification to determine if it is time to take some profits off the table or hedge their current equities exposure to minimize losses and possibly even earn a profit.