Is the Economy Signaling Green Shoots or Rotten Tomatoes?

The economy appears to be making strides as it emerges from critical condition and enters into rehabilitative mode. Some positive signs include increasing bank lending, auto sales, and consumer confidence. Unemployment is also declining, especially for skilled labor. Both the US budget deficit and state budgets are improving. Corporate infrastructure such as plants, buildings, and equipment are overdue for upgrades, suggesting substantial future increases in capital expenditures.

Headwinds from the Euro debt crisis have subsided to a large extent, with credit spreads collapsing. In fact, spreads seem unusually tight given that Spanish bond yields are currently lower than US Treasury yields. This is quite unusual, and likely due to the European Central Bank’s announcement that they will engage in more aggressive monetary easing policies to halt disinflation and spur growth.

Japan and China are still muddling through their own economic malaise attempting to establish equilibrium. In short, the global financial landscape seems eerily quiet, especially given the growing geopolitical pressures. Increased tensions in the Ukraine, civil war in Iraq, and continued presidential scandals have failed to disrupt financial markets. The US stock market, in particular, is experiencing reduced volatility. We are now going on almost three years with no correction of 10% or more (since August of 2011).

The current situation reminds me of my garden. This year I made a vow to finally grow vegetables. I decided to start with something easy and small. I filled a cement container with soil and compost and planted two tomato plants. The plants grew tall quickly; and before I knew it, I had about 15 shiny green tomatoes. I was so excited that I started to plan my recipes, who I would share my bounty with, and what I was going to add to my garden next year. Then one day when I went to check my plants; I found a shriveled up tomato and one that had brown rot on the bottom. Uh, oh. I researched the disease online and now realize that I may not be able to save my tomatoes. I am taking steps to reduce the risk of further rot, but I am concerned that I may be fighting a losing battle.

I may lose a lot of my tomatoes, or I may be able to minimize the losses and still have plenty of tomatoes for weeks to come. The same may hold true about the financial landscape. Although the economy is starting to improve, the stock market seems to have gotten a bit ahead of itself. The market appears frothy, with little room for future growth, but a correction may come in days, months, or maybe years.

Why are stocks and investors so complacent?

The Fed Reserve’s policy of printing money has resulted in a massive increase to their balance sheet from $800B in 2007 to over $4.5T today.

This massive flood of money into the system has drastically devalued the dollar and has forced investors to put their cash in riskier investments. This has been the main reason for the overly ebullient markets since the Great Recession of 2008. In this zero interest rate world, desperate retirees and savers are reaching for yield in risky areas of the market in order to get more return on their money. This has resulted in overvalued fundamentals. Valuations are rich for US equities using metrics that have traditionally been highly correlated to market performance.

Using the CAPE (Cyclically adjusted PE) ratio developed by Robert Shiller from Yale University, the market may be signaling that US stocks are possibly overvalued by 50%, as the ratio is approximately 51% above its average (arithmetic mean) of 16.5.

Of course, valuations can’t be used as market timing techniques, as markets can stay overvalued or undervalued for long periods of time. But at these levels, it does suggest that loading up on equities, especially if you are a new or soon to be retiree, may not be a good long-term move.

According to John Hussman, “The median price/revenue multiple for S&P 500 constituents is now significantly higher than at the 2000 market peak.” He is currently forecasting weak returns over the next decade with negative returns for period of 7 years or less.

Similarly, James Montier from GMO expects that large U.S. stocks will have a return of -1.6% a year for the next seven years.

Mebane Faber in a recent conference suggested that not only US stocks, but particularly dividend stocks are severely overvalued. He also warned that “home bias” skews our portfolios in favor of our own country’s stocks. Right now international markets, especially certain emerging market countries, have better valuations.

The point is that shocks occur when you least expect it. They are often caused by some triggering exogenous factor and are met with disbelief, which in turn leads to unpredictable human behavior.

We need to prepare for inevitable corrections as they are part and parcel of business cycles.

Since this rally is particularly long in the tooth and has created severe overvaluations, it may be a time to mentally and financially prepare for a market setback. While I do not espouse market timing, I do think it is prudent to reduce exposure by 10-20% in the event of extended markets, impending retirements, or in the event that you have reached or surpassed your target financial goals.

Times like these also underscore the importance of re-balancing your portfolio. Re-balancing is the best way to keep yourself unemotional, since you invest based on your target allocation as opposed to market noise. This is why I always urge my client’s to be faithful regarding their annual reviews.

When you re-balance or take some actions to reduce risk, you not only enhance your awareness of your financial well being, but you feel more in control of your situation. When it comes to investments, we can’t control the economy or the direction that the markets will turn, but we can and should control the things that we can, such as reducing costs, planning to avoid tax spikes, and maintaining an exposure to the stock market that is consistent with our risk profile and market valuations.

In order to reduce the risk of losing more tomatoes to disease, I bought some gypsum and added it to the soil in my tomato plant container. I don’t know if it will work, but I at least feel better that I did all that I could to help prevent the spread of the disease. I hope to have an abundant garden this summer, but only time will tell.

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