Photo Credit: Miles Nicholls || Actually, the bells get rung at the top, and quite frequently for the duration of the process. People hear it and they decide not to listen. Too many false alarms.
The stock market model is projecting a 3.06%/year return over the next ten years as of the close on 11/15/2019. That’s near where a 10-year mid-single-A rated bond would trade. That’s not offering a lot of compensation for putting your money at risk.
I’m planning on reducing my total risk level by 15% or so, moving my equity allocation from around 70% to 55%. That will be the lowest it has been in two decades. I’m not running to do this. I am still working out the details.
The Fundamentals of Equity Market Tops
You might recall an old piece of mine that I wrote for RealMoney back in January 2004 — The Fundamentals of Market Tops. In it, I gave a non-technical analysis approach to analyzing whether we might be near a market top. In 2004, I concluded that we were NOT near a market top. (This article also served as a partial template for the article at RealMoney in May 2005, which said that YES we were near a market top for Residential Real Estate. Two good calls.)
The article is longer than most, should not fit in the TL;DR bucket for most investors. I’m not going to reconstruct the article here, but just give some brief points that fit the frame of the article. Here I go:
- Value investors have been sidelined. Growth is winning handily.
- Valuation-sensitive investors are raising cash. Buffett sitting on $130 billion is quite statement. He’s not alone. More on that below.
- Momentum is working.
- There has been a decline in IPO quality.
- Lots of money is getting attracted to private equity.
- Corporate leverage is high, and covenants are weak.
- Non-GAAP accounting gets more attention than it deserves.
- Defined benefit plans are net sellers of stock, but not for the reasons I posit in my article — they are doing it to move to private equity and alternatives, and bonds as a part of liability-driven investing.
Cutting against my thesis:
- More companies are committing to paying dividends, and growing them. I’m impressed with the degree that corporations are thinking through their use of free cash flow, even as they lever up.
- Actual volatility isn’t that high.
- The Fed is supportive.
On net, these conditions give some confirmation to what my quantitative model is saying… the market is near a top. Could it go higher still? You bet, with an emphasis on the word “bet.” The S&P 500 at 4500 would be where valuations were during the dot-com bubble.
Asset-Liability Management and Market Tops
I want to emphasize one point, and then I am done. I wrote another article called Look to the Liabilities to Understand the Assets. There are a few more like it at this blog.
The main idea as applied to the present is this: when you have “strong hands” (those with long time horizons and strong balance sheets) raising cash levels and those with “weak hands” (those with shorter time horizons and weaker balance sheets) staying highly invested in risk assets, it is a situation that is unstable. Those that have capability to “buy and hold” are sitting on their hands, whereas those who have to get returns or they will suffer (typically municipal defined benefit plans and older retail investor who didn’t save enough) are risking a great deal, and have little additional buying power.
This is unstable. This situation typically exists at market tops. Remember, it is what investors DO that is the consensus, not what they SAY.
With that, consider your risk positions, and if you think you should act, do so. If you are uncertain, you could ask an intelligent friend or do half.
Very good article. I agree with your conclusion.
I recognize that the model forecasts returns for the US market as a whole. Any conjecture on returns for value vs growth stocks over the period? I expect that value is poised to outperform, but not sure by how much?
IMO the bull won’t end until either the Fed kills it (which will only happen if they’re forced, by an inflationary breakout), or the equity risk premium gets compressed to something like 2%. That implies an SPX forward P/E of around 26.
We have a long way to go – it could well take another decade. Most market participants still expect Fed “normalization” at some point; we will need to see total capitulation to the idea that rates will NEVER rise materially. Institutional memory of the GFC will need to fade away. Old-school value guys like Buffet and valuation bears like John Hussman will need to have long since left the stage (I feel bad for Hussman, but I’ve thought for years that the next top won’t arrive until he shuts his fund).
And none of this will be wholly irrational: what’s the point of accepting any significant yield penalty to hold bonds, let alone cash, when the central bank has kept an ever-rising floor under the stock market for 10, 15, 20 years?
How do you define the equity premium? By my measure, stocks are poised to return 3.06%/yr over the next ten years while the equivalent Treasury note yields around 1.76%. Forward looking, that is an equity premium of only 1.3%/yr. Pretty thin.