With the S&P 500, Dow Jones Industrial Average, and Nasdaq 100 all within a stone's throw of their 52-week highs, there is no need to rush into new positions at this time.
Typically, when investors debate whether or not the market is a buy at certain levels, valuations play a key role in those discussions. In this article, I would like to take a different approach. First, I would like to present some food for thought regarding whether you will have an opportunity to buy the major indices in the future at current levels or lower. Second, I would like to provide a more concrete and less hypothetical reason why there is no rush to purchase the major indices at this time.
There is never a shortage of investing pundits willing to make the case that investors should be putting new money to work in stocks. This occurs regardless of price or valuations. Data can be sliced and diced in a variety of ways to make a case for pretty much any call you want to make on stocks (buy, hold, or sell). Investment professionals are experts at making virtually every moment sound like a "long-term buying opportunity." However, when thinking through the slow growth environment in which the world is mired and the very real possibility for any of a variety of things to cause a bear market over the coming years, you may find the following to be worthwhile food for thought when thinking through whether you should rush new money into stocks at current levels.
If you were reasonably certain the S&P 500 or any other equity index or stock you were interested in purchasing would trade at or below today's levels at any point in the future, would you buy it today? With this in mind, I asked myself at what levels the S&P 500 would have to rise to prior to the next bear market in order to give investors the chance to purchase the market at today's levels at some point in the future.
During each of the past two bear markets, the S&P 500 declined 50.51% (2000 to 2002) and 57.69% (2007 to 2009). I recognize that those declines had a lot to do with a massive valuation bubble in technology stocks and a financial crisis. The next bear market might not resemble those situations. However, it is also important to recognize the role that leverage plays in driving prices to extremes, both during bull markets and during bear markets. With margin debt on the NYSE now hovering between the peak levels it hit during the tech bubble and the levels it hit in 2007, I think it's fair to say there is enough leverage built up to cause a decent size bear market whenever the time comes for institutional players to start selling.
I created the chart below to illustrate the strong directional correlation between stock prices and margin debt on the NYSE. It shows margin debt on the NYSE from January 1994 through June 2012 vs. the monthly closing prices of the S&P 500 during the same time frame. If history is any guide, a further rise in stocks is likely to be accompanied by a further rise in margin debt on the NYSE. This will only add more fuel to the leverage-unwinding fire when the next bear market arrives.
Even if you don't believe a 50%-plus sell-off is in our future during the next bear market in U.S. stocks, spend some time thinking about what you project a realistic sell-off will be during the next bear market or pullback. Then, in the table below, find the sell-off you would realistically project during the next bear market or pullback. Match this to the corresponding level on the S&P 500 at which the sell-off could begin in order to bring the index down to today's level of 1,416 at some point in the future.
Starting Point For S&P 500
Sell-Off During Next Bear Market / Pullback
Today's Level For S&P 500
If you think a 40% sell-off during the next bear market is a realistic possibility, especially given the rising levels of margin debt that seem to accompany rising stock prices, ask yourself whether you really need to rush into stocks today. Even if the S&P 500's multiple expands to 16, which I've heard many pundits argue the index should trade around, in order for the S&P 500 to rise to 2,360 earnings will need to grow another 45% from the current year-end 2012 estimate of $101.70.
I'm sure there are investors who prefer not to play the game of trying to guess whether the market will trade at or below today's levels at some point in the future. For those investors, I offer a second reason why there is no rush to buy at today's prices. It has to do with put options.
A put option gives its owner the right, but not the obligation, to sell a security at a particular price by a certain date. On the other hand, the seller of a put option has the obligation to purchase a security at a certain price by a certain date if shares are assigned to the investor or if the put option closes in-the-money on expiration. While many investors hope the options they short end up expiring worthless, there are times investors may want the options they sold to be assigned. By selling deep in-the-money put options, an investor gives him or herself the opportunity to purchase a security at a price he or she chooses. If you want to buy yourself time when deciding whether to purchase an equity index at today's price but also don't want to miss the opportunity to purchase at today's levels, selling deep in-the-money put options can help you accomplish this.
Currently, the iShares MSCI EAFE Index Fund (EFA) is trading at $52.28. If you are willing to purchase it at this price but are nervous about events in the coming weeks causing a pullback in the index, you should track the values of the long-term, deep in-the-money puts on EFA. For example, the Jan. 18, 2014 expiring $70 puts are currently bidding $19.85. If you sold these puts and were forced to get long EFA, your cost basis would be $50.15, ex-commissions ($70 minus $19.85). This is $2.13 below its recent price of $52.28.
Rather than selling the puts at these levels, simply watch that put option's bid price. If the MSCI EAFE Index continues higher, an investor who doesn't utilize options will have missed an opportunity to get long at $52.28. However, the investor willing to sell a deep in-the-money put on EFA can wait until the bid on the $70 EFA January 2014 puts declines to $17.72 before needing to pull the trigger ($70 minus $17.72 equals $52.28). This buys the investor time. The market can go higher, but because of the premium on the put option, the investor doesn't need to get long right now.
What is the risk to this strategy? If EFA is trading above $70 on option expiration, the put seller will not be assigned shares of the ETF. This means the investor's upside would be limited to $17.72 (ex-commissions), 33.89% above the recent price of $52.28.
This same exercise can be repeated on other indices and stocks as well. Given the popularity among hedge fund managers and retail investors of investing in Apple (AAPL), let's take a look at Apple's long-term, deep in-the-money puts. Currently, the Jan. 18, 2014 $970 puts are bidding $328.80. This means the seller of that put option, if assigned shares of Apple, would have a cost basis of $641.20 (ex-commissions). Apple is currently trading at $665.15. In order to get long Apple at $665.15, the put seller could wait until the bid on the previously mentioned put declined to $304.85 before selling the option. This buys the investor time to watch the market and make a decision about whether today's prices represent value.
Naturally, an investor could perform this exercise with any number of ETFs and stocks as well as with any number of strike prices and expiration dates. The goal of this strategy would be to buy yourself as much time as possible before getting long at today's prices while also choosing a strike price that gives you as good a chance as possible of being assigned. Under this time buying strategy, you want to be assigned shares of the underlying security.
In an era when central bankers and politicians are having such a profound impact, both directly and indirectly, on the prices of financial assets, it's quite hard to predict the direction of prices over any time frame. Sometimes using history, in the context of bear market sell-offs, or other trading strategies such as selling deep in-the-money put options, can help an investor become more comfortable with waiting. After the recent strong rallies in many popular major market indices, there is no need to rush to buy stocks at these levels. Let's first wait and see if market speculation about solutions to Europe's woes and QE3 bear any fruit.