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Is The Market Safe At Current Levels?

|Includes:SPDR S&P 500 Trust ETF (SPY)

For many years, I've tracked the level of the S&P 500 as a proxy for the market, using a ratio between the index and GDP as a measuring tool. Last week, the market crossed a brightly painted line - 1,498 on the S&P 500, which is the midpoint value by my methods.

Measuring Market Level

For an explanation of this line of thinking, here's a link to an article I wrote in October 2011. Here's the current output of this model:

From a common sense point of view, with the market at its 50th percentile, there is no compelling reason to invest in stocks - nor is there any compelling reason to avoid them. For long term investors, it's constructive to look at expected returns, and weigh them against the risk of loss. For the purposes of this article, I'm thinking in terms of expected one year returns.

When the market is between 10 and 50 (out of 100) in terms of market level, capital appreciation for the next year averages 10.5%. From 50 to 90, it averages 3.5%, to which one could add the dividends. So we have now crossed the threshold into an area of lower expected returns, something on the order of 5.5% to 6.0%. There is no market level that doesn't have a positive expected one year return.

Measuring Risk

A primary cause of negative equity investment returns is financial stress. Here is financial stress, as measured by the STLFSI:

I did a study on this topic, and published the results here on Seeking Alpha. Here's a table, relating stress level to forward returns, again for one year:

Briefly, when financial stress is between 0 and -1, forward returns are very attractive at 11.8%, and positive 85.7% of the time. That's the power of the Fed. By way of a cautionary statement, when financial stress is extremely low, forward returns are negative. That's the Fed for you, or lack of prudential regulation of financial services.

Business Conditions

Let's take a look at business conditions, as measured by the Philly Fed.

Conditions are positive. As a practical matter, one year forward returns are not as sensitive to business conditions as one would imagine. They are better when conditions are above average, 0 to 1, and poorer when below average, 0 to -1, but nothing to hang your hat on for investment decision making. Again, a cautionary statement: when business conditions are extremely good, one year forward returns are poor.

Investment Implications

Financial Stress and Business Conditions portray relatively low risk, and are at levels associated with acceptable one year forward returns. Market level is at the midpoint, and at a level associated with relatively weak forward returns.

I've been transitioning my portfolio from an emphasis on Deep Value toward a strategy based on selecting from among stocks with Dividend Growth credentials. Based on my interpretation of the information discussed above, I expect to have time to make the transition in an orderly fashion. Meanwhile, I'm building a hedge with deep in the money S&P 500 puts, while volatility is low and premiums are affordable. I add to the hedge each time SPY advances by $1.

Stocks: SPY