Equity Markets Appear Overbought

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Includes: DIA, QQQ, SPY
by: FP Trading Desk

History shows that the bigger the economic bust, the bigger the subsequent snap back. So since the current downturn is the largest on record other than the Great Depression, the rapid and large surge in equity prices since March might come as little to surprise to some.

With the S&P 500 P/E having expanded by six to eight multiple point since the low about five months ago, RBC Capital Markets chief institutional strategist Myles Zyblock thinks the equity market appears overbought. He told clients that the situation is similar to the set-up last seen in late April.

“Investors might use this combination of valuation expansion and strong price gains as motivation to lighten up,” he said. However, RBC isn’t changing its strategy. It is emphasizing that sell-offs will offer opportunities to add to existing positions. Mr. Zyblock highlighted what he considers the critical factor motivating investment behaviour: the marginal change in the economic and earnings outlook.

“Investors are usually willing to pay higher multiples and take on more risk as they gain increasing confidence in the outlook,” he said, looking back to the valuation overshoot already in place by 1998. “That didn’t stop the multiple from expanding further and prices from rising another 50% before the market reached its dizzying apex in 2000.”

The strategist is confident that macro indicators will provide enough information to make risk adjustments for portfolios relative to prevailing market conditions. “These indicators have offered solid guidance over time, but prove even better at confirming market tops and bottoms during secular bear markets like the one lasting from 1966 to 1982.”

Mr. Zyblock said the cyclical indicators continue to suggest holding a higher-than-normal level of portfolio risk. However, if the savings rate rises to 8-12% (as was common prior to the late 1980s), there could be a significantly negative impact on the trajectory of the economic and earnings recovery. Under these assumptions, the strategist suggested that portfolios be rather defensive. This means favouring Consumer Staples over Consumer Discretionary.

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