What would you do if the market fell over 50%?
It is our opinion that investors should stress test their portfolios for a significant decline in asset prices in the coming years. Investors should make sure that they can handle equity values being cut in half. If you can handle this outcome in stride, then your allocation is potentially appropriate. If not, you should consider seeking guidance in structuring a portfolio more in line with your objectives and constraints.
Our market commentary centers on the following four factors: valuations, market internals, economic conditions and Fed policy. Our conclusions are summarized below.
- Valuations are still extremely stretched and represent one of the most overvalued markets in history. In fact, according to the measures that have the highest correlation with average returns over the next 10 years, the market is the second most overvalued ever. The only time where market valuations were more egregious than our current cycle peak was during the technology bubble. Valuations matter over the long term and suggest that if an investor bought the market today and held it, they should expect 0-4 percent over the next 10-20 years. Despite what most market prognosticators would have you believe, valuation metrics tell us very little about what the market will look like one year from now.
- Market internals, give us a great indication of how strong the market is underneath the hood. Up until recently the stock market has been supported by strong and strengthening internals. Starting last year, however, cracks started to show in credit spreads and divergences became apparent. Fewer and fewer names appear to be holding up the indexes. Buy backs have been a large percentage of the volume this year and as Carl Icahn has warned, have an unusual manipulative influence on the market. As Dr. John Hussman has suggested in his wonderful weekly commentary several times, strengthening market internals would result in a resurgence of a bullish tone despite the unfavorable valuations, economic conditions, and Fed policy.
- The economic environment has deteriorated across the board over the last year. Growth is slowing and many of the measures we use that have a historical correlation with upcoming recessions and market deterioration are flashing warning signals. Corporate profit margins have peaked over one year ago, earnings are deteriorating, the ISM is now below 50, industrial production is negative year over year, and the consumer is lackluster from a historical perspective. Furthermore, the strong dollar is a major headwind reverberating deflationary tones throughout our economic engine. Global growth is slowing as well as the stronger dollar has caused immense pain in the emerging market economies. Developed economies are strangled by too much debt and emerging markets are being punished by stalling global growth and dollar based deflation.
- Divergent central bank policy will continue to be a main force behind market moves in the near future. The United States Federal Reserve has moved off of the zero bound while 65 global central banks have moved policy more accommodative. The Fed beginning their tightening path, albeit slowly, will have profound effects on risky markets. The reason is because the US dollar should maintain its posture as the cleanest dirty shirt (hat tip to Bill Gross). A stronger dollar will continue to pressure profit margins and hurt economic growth domestically and in the emerging economies. The only hope would be that Europe, China and Japan come back online in a dramatic fashion due to their quantitative easing and weak currency initiatives. In our opinion, if deterioration continues, the Fed will have to quickly reverse course and possibly move to negative rates. We will have to wait and see.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.