Time to Lighten Up on Stocks?

The hotter today’s market gets, the more likely investors are to get burned, experts and indicators say

The stock market has its head in the clouds again. Not only are we at all-time highs, but basically, everything is fantastic.  

Profitless companies are skyrocketing in value, school kids with really cool mobile apps are becoming overnight billionaires, and the investing public’s fear of missing out has returned with a vengeance.

The only bubbles Wall Street sees right now are the bubbles in its champagne glasses.

Describing the utter lunacy of today’s market climate, Josh Brown of Ritholtz Wealth Management, author of Backstage Wall Street, wrote recently, “I told Mark Zuckerberg that my daughter’s lemonade stand was “the next Facebook” and he bought her out for $24 billion. So I’m basically retired now.”

It seems the more things change, the more they stay the same.

One of the behavioral disorders repeating itself is the “this-time-is-different syndrome.”

Explaining the genesis of this particular sickness, economists Carmen Reinhart and Kenneth Rogoff explained, “It is rooted in the firmly held belief that financial crises are things that happen to other people in other countries at other times; crises do not happen to us, here and now. We are doing things better, we are smarter, we have learned from past mistakes. The old rules of valuation no longer apply.”

What about political instability and other troublesome developments in emerging markets? (See Argentina, Brazil, China, Russia, Thailand, Turkey, Ukraine and Venezuela.) Apparently, the U.S. stock market isn’t bothered by the blood in other people’s streets.

What about stock valuations?

Five models for valuing stocks, including the Shiller PE and Tobin’s Q, project a blended return of zero percent over the next seven years. The least optimistic and perhaps most realistic? The Shiller full mean revision model suggests a 3.2% loss.

Did I just say the word loss? Oops, I apologize.

It’s worth mentioning that grossly overvalued stocks aren’t necessarily a prerequisite for sharp corrections to occur. Remember 2007?

In October 2007, the S&P 500’s P/E ratio was just 19.42 compared to a frothy 29.41 in March 2000. Stocks in the fall of 2007, by historical standards, were a screaming bargain compared to the stock market of 2000.

But that still didn’t stop stocks from declining almost 50% over the following 18 months. 

Nobody knows if 50% losses are where this market is headed, but what we do know is that trading volume is down and fewer and fewer companies are participating in the rally.

The S&P 500 may be at record highs, but just 95 stocks hit new 52-week highs as of Feb. 27, which is a far cry from the S&P’s May 2013 peak when almost 200 companies confirmed the top.

Furthermore, previous bull markets in the 1980s, 1990s, and 2000s all occurred on brisk trading volume, which is not the case with the post-2008 bull.

In fact, the S&P’s five-year advance has occurred on below average trading volume. Not only does this particular bull market have less conviction compared to previous bulls, but the above average trading volume during this particularly cycle is closely aligned with stock market selling. (See chart.)

Risk managers, take note and do your job. The precise time to exit a burning building is before the fire, not after the building has burned to the ground.

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