By: John Del Vecchio
Talk about mixed signals… which, of course, is itself a solid indication that things are getting harder in the market.
The pros and the eggheads are getting cautious. The average individual investor is not.
How will the tension resolve?
Well, investment banks are getting bearish. Should we accord these Masters of the Universe any special attention?
Under most circumstances, the answer is, “NO!!!”
Wall Street firms are notorious for picking their clients’ pockets. That’s how Masters of the Universe fund their fancy vacations, private jets, elite schools, and tony estates: by taking the opposite side of client trades.
But, sure, it’s interesting that Goldman Sachs recently warned investors of lower returns ahead.
And, while the “great vampire squid” isn’t calling for a nasty bear market, it is approaching stocks with caution.
Rather than just accept its conclusion, though, I’ve reviewed my own metrics to see where we are and what we should do about it.
Let’s start here: Valuations are rich.
I like to look at market valuation relative to revenue. And we’re in uncharted territory here, an all-time record.
The S&P 500 Index is priced at 2.63 times its median price-to-sales ratio. Back in the heady days of the dot-com bubble, we hit about 1.8 times. And it went as low as 0.8 times in early 2009. (It’s easy to see now, but that’s a screaming buy.)
Let’s take a look at how individual investors have allocated their portfolios. The portion dedicated to stocks isn’t at record levels. But it’s close.
At 70%, we’re (un)comfortably are in the danger zone. And cash levels are at 16%, down from 45% at the beginning of the bull market.
At the same time, consumer confidence is skyrocketing.
Professional investors, meanwhile, are 85% invested in stocks, which is the functional equivalent of “all in.” They’re way too optimistic, too.
And let’s not forget that investors of all stripes are leveraged to the gills.
OK, how about the macro picture? Well, the Federal Reserve Bank of New York recently raised its measure of the probability of a recession to 15%.
That’s still “low” – it was 40% prior to the Global Financial Crisis/Great Recession. But it’s as high as it’s been in 10 years.
“Direction” is the real key: The New York Fed’s recession meter has been trending up for a while…
When everyone’s feeling flush and willing to spend, I hide my dough in a coffee can and bury it out in the backyard. The time to get the best deals is when everyone’s fearful.
But we’re still very far from fearful.
This complacency is a function of the fact that interest rates have been so low for so long. Interest rates are rising, and we’re starting to see smaller, “growth” stocks underperform.
And we could be in for a particularly volatile earnings season, as investors look to justify their holdings in the face of updated operating and financial numbers. At the very least, companies carrying large debt loads will see some cash flow eaten up by higher interest costs.
This combination of rich equity valuations and overly optimistic sentiment has been suggesting lower stock returns ahead for years. And still we rise.
So, what to do?
I’m going to keep my eyes on one trusty indicator, the 200-day moving average.
Since 1929, returns are nearly six times greater when we’re trading above the 200-day moving average of stock prices. And stocks are barely positive when the market is below the 200-day moving average.
So, a strategy built around investing when the market is above the 200-day moving average trumps a buy-and-hold approach.
A break of the 200-day moving average could signal that it’s time to get defensive. That’s when I’ll start to cut risk.
Unless the stock market crashes, odds are extremely high we’ll cross the 200-day moving average before any nasty bear market occurs.
It’s important to recognize the risks in the market right now.
But it’s equally important to not overreact.
The 200-day moving average helps me take emotion out of the equation. It’s how I let “price” tell me when it’s time to move to the sidelines.
It’s how I sleep at night amid crazy valuations and rising volatility…
-Originally appeared in the Rich Investor.