The Unpunished Forecasters
Forecasts and predictions are constantly flooding our news feeds. They typically pull one data point out to "substantiate" their claim. On any given day you can find predictions that the market is going up, down, and sideways. Why so many, so different? I would argue there are three reasons.
- There are no consequences for being wrong (unless the predictor takes action in-line with prediction).
- Everyone is trying to stand out as the smartest person in the room.
- The forecaster has done very diligent research pointing towards a high probability event (the most infrequent type of prediction).
Getting a prediction right is a great feeling, but no one keeps tabs on your success rate. When I was younger, I constantly told my older (significantly stronger) brother I could beat him up. This inevitably led to me getting punched repeatedly, except this one time when I got the better of him (or he just slipped on our kitchen floor). To this day, I remind my brother of my accurate prediction that I could beat him up.
My point (other than, yeah, I can beat up someone) is don't put too much weight in forecasts or estimates. Instead, let's deal in our current reality where there is data and fact. What is the current reality of the market?
Based on the Shiller P/E and TMC/GDP, the market is over-valued.
While a useful gauge of the market, the Shiller P/E uses micro (cumulative corporate) earnings. This is a problem in valuing the entire market. Here is a basic overview of the difference between micro and macro earnings.
This was taken from a very insightful paper by Stephen Jones. The two important differences are government net borrowings and personal savings (which I will touch on later).
By using TMC/GDP, we are using macro earnings compared to the total market cap.
So both the Shiller P/E and TMC/GDP are telling us that the market is currently over-valued, but not to past extremes.
I need to be clear that the market is over-valued based on the two metrics, BUT this is not to say the economy is in terrible shape.
*This is real GDP growth (inflation adjusted).
How much of this is sustainable growth? This brings me back to government net spending and personal savings. Through three phases of quantitative easing, the Fed keeps spending money. This spending depresses interest rates, which limits personal savings. Neither are sustainable -- the government cannot spend forever and personal savings are obviously limited. So GDP is growing, but not all of that growth is coming from a sustainable source.
In general, there is an economic "pullback" every 5-7 years (2014-2008 = 6 years!). THIS IS NOT A GUARANTEE, JUST A RULE OF THUMB. The Fed has prolonged any pullback by its spending, thus, creating the aforementioned unsustainable growth. The source of this 5-7 year "rule" comes from Ray Dalio in this well-made video (not a deep dive, but well worth the watch).
- Don't put too much weight in any given forecast or prediction
- The market is over-valued, but not to an extreme degree
- The U.S economy is growing, but a portion of this growth is unsustainable
What I Suggest
Here are three suggestions (if you believe the market is overvalued).
- Trim positions in higher valuation holdings. For example, I recently liquidated my Google (NASDAQ:GOOG) (NASDAQ:GOOGL) long position solely due to its high P/E, EV/EBITDA, et al.
- Add defensive stocks. Think Clorox (NYSE:CLX), Wal-Mart (NYSE:WMT), or Berkshire Hathaway B Shares (NYSE:BRK.B).
- Increase your cash position. My personal approach is to increase my cash position by 10% for every 5% increase in TMC/GDP above 105%. So at 122% TMC/GDP, I'm at 30% cash. I hate holding cash, but my mechanized approach saves me from me.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.