Are Stocks Too Pricey For The Risk?

| About: SPDR S&P (SPY)

Summary

Retail investors have been led to believe that P/E is the gold standard for stock valuation. Taken alone, this has created undue bearishness in the stock market.

Assessing risk/reward is a holistic endeavor, but one that is near impossible for those who don't have access to complex analytical algorithms and/or supercomputers.

Building risk/reward charts can simplify the task for most investors. However, don't confused them with technical analysis. Risk/reward chart lines should be based on expected growth, not historical stock performance.

Hoisington Investment Management recently released its " Quarterly Review and Outlook" for the second quarter… and it was a doozy. In my opinion, they missed the point on a few things, but I still recommend reading it.

The source of their misconceptions was common. Analytical humans rely too much on numbers and history. While numbers and history can be instructive, the future never truly repeats. More importantly, numbers don't create events - it's the other way around.

Bearish investors are currently succumbing to this, in my opinion. Many say that the bull market has run its course because valuations are at all-time highs. They point to historical valuations (P/E, CAPE, etc.) as a guide.

However, they also say that they expect economic growth to remain tepid for years to come. This will presumably keep interest rates at low levels until inflation or economic growth reaccelerates.

How can it be both? If interest rates yields remain low (or get lower), then stock-earnings yields should also stay low (or get lower), unless risk premiums increase (which isn't the argument being made by the bears) or inflation starts running too hot.

In Japan, this dynamic resulted in P/E ratios that remained persistently high for several decades.

Click to enlargeSource: siblisresearch.com

This is why I pay attention to the market's position on long-term Risk/Reward charts (see below). When drawn to reflect sustainable fundamental growth rates, a Risk/Reward chart can help an investor account for all bullish and bearish sentiment in one easy-to-read picture.

Many will call this technical analysis, but it's not. In a Risk/Reward chart, the trend lines are drawn to represent the logical growth rate of the underlying entity, not simply connecting tops and bottoms.

Not surprisingly, the two will often be one and the same. They should be, because valuations should reflect reality (even though they often don't).

Click to enlargeSource: PipelineDataLLC.com

As you can see from the Risk/Reward chart above, the stock market is at historically elevated levels. However, there is still some room for upward movement (which would logically stem from a further expansion in P/E ratios in the face of still-declining risk-free interest rates). However, if our slow-but-stable environment should hit an obstacle, the downward correction could be dramatic (as you can also see above).

This is the beauty of understanding the risk/reward of any situation. In this case, stocks have two ways to rise (by moving to the very top of the channel or simply by riding along the ever-rising slope). However, investors must remain cognizant of the risk that a 20-40% correction could hit (which is relatively common; something you can also see above).

In other words, a correction will need to be avoided for several more years to justify being fully-invested without any protection in place. This is why I'm currently neutral on the market, but with an eye toward becoming bearish (again).

How Did We Get Here?

In my opinion, our current predicament started long before Alan Greenspan's irrational exuberance speech on December 5, 1996. By the way, he was right (Internet Bubble notwithstanding). Twelve years after he gave that speech, the Dow was sitting at the same level, much to the chagrin of long-term investors.

The problem stemmed from global demographics. After the end of World War II, a global baby boom ensued. This was a boon for economic growth. Anyone with children can tell you why -- spending. In a perfect world, the powers-that-be would adjust fiscal and monetary policy according to upcoming demographic, immigration, and productivity trends, which have an indelible impact on future GDP growth (and are fairly easy to predict).

Instead, the powers-that-be always push the envelope of growth to its limits. The reason is simple. Growth makes people (voters) happy. Happy voters re-elect incumbents. So, incumbents have little incentive to rein things in when the party starts getting too crazy.

This was the case as the Baby Boom peaked, in the late-1950s. It was also the case when the Echo (Millennial) Boom peaked in the early 1990s. But instead of turning down the music a bit, policy-makers let the party rage on.

As you can see below, Federal Debt to GDP was reined in after the baby boom peaked. This likely prevented the economy from crashing worse than it did in the early-70s (note that Debt to GDP wasn't reflated until the early-80s, which coincidentally marked the beginning of an 18-year bull market). The combination of Millennial births and easy fiscal/monetary policy made for economic nitrous oxide.

But it wasn't until after Greenspan's famous speech that Debt to GDP started to get reined in. According to the demographic profile of our country at the time, this should have started sometime in the mid-80s. The Echo Boom was more than enough to keep the party going at a sustainable rate. Instead, we broke out the hard liquor and headed toward the inevitable blackout.

People credit Reagan and Clinton for some economic wonders of the past. However, the reality is that demographics made it a virtual fait accompli.

Despite all of this (and common sense), the powers-that-be feel compelled to keep pushing debt-to-GDP ever higher. In reality, that might be the right move now, but only because we can't rely on traditional growth drivers (like demographics) to drive growth. The problem is this - quantitative easing should have come off of a much lower Debt-to-GDP base.

This should have started in the mid-80s and persisted through the end of the Echo Boom in 2000. If it had, we might have bypassed the Internet bubble (and bust), along with the Real Estate bubble (and bust).

But now it's too late. Worse, long-term harm is being done to our prospects for future growth and our generation of Millennials. This is a big part of the reason why Donald Trump's campaign has met with so much success. People are sick and tired of being told to have hope while being forced down an economic rat hole.

Instead of prospering and reproducing, our Millennials are increasingly staying at home with mom and dad.

While this is great for family closeness, it's a disaster for economic growth. Based on normal demographic cycles, a new baby boom was due to begin a few years ago. Instead, the fertility rate is sitting at all-time lows.

This is reminiscent of how things played out in Japan. Despite this, "we" are still choosing to follow the same path.

Click to enlarge

Of course, this could lead to higher P/E ratios (and perhaps valuations) for the time being, but it will put severe restriction on future asset returns. The plight of the Nikkei (and our Risk/Reward chart) illustrates this. There's only so far you can push near-term growth until long-term constraints take hold.

That doesn't prove that I'm right about all of this. However, I believe that common sense thinking about our current situation does… and that is often more powerful.

Accordingly, I continue to advocate the use of hedges. The simplest way to do this is to short the SPDR S&P 500 Trust (NYSEARCA:SPY) or to buy some of the ProShares Short S&P 500 ETF (NYSEARCA:SH). I provide specific shorts via my Seeking Alpha blog and my free Pipeline Data Newsletter (at PipelineDataLLC.com) for those who wish to utilize more effective, and often profitable, insurance.

But don't call me a bear for taking this approach. I've been bullish for the majority of my 20+ year career. However, the concept of risk and reward is just a simple matter of using math to optimize (and often preserve) your profits and wealth.

Heeding the risk/reward warning signs worked in 2000-2001. It also worked in 2007-2008. My customers and I were short (or much less long) during those periods of time. Similarly, retail investors who paid respect to the tilting balance of risk and reward were able to circumvent (or even profit from) those two major market declines.

I expect it to work this time around, as well. Effective use of Risk/Reward charts almost always does.

Disclosure: I am/we are short SPY.

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.

Additional disclosure: The information in this article is for informational and illustrative purposes only and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. The opinions expressed in Pipeline Data, LLC publications are the opinions of Mr. Gomes as of the date of publication, and are subject to change without notice and may not be updated. All investments carry the risk of loss and the investment strategies discussed by Mr. Gomes entail a high level of risk. Any person considering an investment should perform their own research and consult with an investment professional. Additional important disclosures can be found in the Important Disclosures section at PipelineDataLLC.com.