I am ecstatic that the majority of my client base had 65%-70% long exposure in lower-volatility stock ETFs over the last two trading sessions. The S&P 500 picked up roughly 4.5%, which means that these portfolio balances rose approximately 3.0% since the U.S. Federal Reserve promised to be “patient” with respect to raising overnight lending rates. Many of the core holdings – iShares USA Minimum Volatility (NYSE:USMV), SPDR Select Sector Health Care (ARCA:XLV), Vanguard High Dividend Yield (NYSE:VYM) – are the same ones that I have held since December of last year or longer.
Yet I am equally elated that I offset global economic risk with a barbell approach to late-stage bull market investing. Extraordinary stock bullishness may have hammered extended duration U.S. Treasuries on Wednesday and Thursday, but Vanguard Extended Duration (NYSE:EDV)) remains in a long-term technical uptrend. It is also up 40.4% year-to-date; the S&P 500 has been far more volatile on its way to 10%-plus in 2014.
The questions that need to be addressed as investors gear up for 2015 are: (1) Can the U.S. economy continue to accelerate if the rest of the world continues to decelerate, (2) Is it sensible to ratchet up one’s exposure to U.S. stocks as though U.S. stock overvaluation no longer matters, and (3) Is it wise to ignore signs of amplified exuberance? I will address these inquiries one at a time.
1. Can the U.S. Economy Continue to Accelerate if the Rest of the World Continues to Decelerate? The answer is, “Not a chance.” Either the U.S. will succeed at hauling the rest of the globe out of its collective ditch, or the rest of the globe will drag the U.S. down into the deflationary hole.
Do not fall prey to those who write eloquently about the unique nature of the U.S. economy – one that can magically sidestep the world’s troubles as though it exists on a self-sustaining island. Not only is history quite clear on the U.S economy’s inability to expand at accelerating rates when the European and Japanese economies are weak – not only does weakness in emerging areas from China to Russia to Brazil to the Middle East increase the risk of geopolitical shocks – but the U.S. economy is expected to thrive while the Federal Reserve looks to slowly tighten monetary policy. Equally concerning? Bank of America anticipates that monetary stimulus from the easing in Japan and Europe would only offset about one-third of the lost stimulus from the U.S.
Form my vantage point? The economic environment in developed and under-developed nations may actually show some signs of improvement in the years ahead, but the U.S. will revert to its mean growth (2%) of the 21st century. There can be no “renaissance” when central banks distort natural cycles of expansion and contraction.
What does this mean for the investor? Perhaps ironically, it may force the Federal Reserve to be unnaturally patient – so accommodating that any modest increase in rates will be quickly reversed by year-end 2015. Safe havens like iShares 10-20 Year Treasury (TLH) will continue to provide value and 10%-plus corrections should prove to be reasonable entry points for overvalued, albeit, well-diversified stock funds like Vanguard Value (VTV). As always, I recommend protecting those buy orders with stop-limit loss orders.
2. Is it Sensible to Ratchet Up One’s Exposure to U.S. Stocks as Though U.S. Stock Overvaluation No Longer Matters? Of course not. Nevertheless, scores of writers and “talkers” have completely dismissed the mountain of overvaluation evidence with empty statements like, “Lower interest rates justify higher stock prices.” That may be true on the surface, but it is not true when stock prices are 50% above the historical average for cyclically-adjusted P/Es.
Other measures of stock overvaluation are equally unkind. There is the Nobel laureate in economics, James Tobin, who hypothesized that the combined market value of all the companies on the stock market should be about equal to their replacement costs. Mr. Tobin’s “Q Ratio” value sits near the top of every major bull market that history has to offer, with the exception of the dot-com bubble in 2000.
Perhaps you do not wish to mind your P/Es and Qs… that’s fine. Can we at least agree that Warren Buffett knows how to value stocks? The last time that Mr. Buffett’s favorite valuation metric (total market capitalization-to-GDP) was this out of whack? 1999. In other words, value-oriented investors would not touch this market with Mr. Buffett’s wallet, Mr. Tobin’s calculator or Mr. Shiller’s 10-Year cyclically-adjusted P/E.
None of these facts about overvaluation suggest that one should sell his/her stock assets outright. In fact, if you share my opinion that the Fed will not get very far in its efforts to “normalize” rates – if you share my belief that rate normalization would harshly punish the excesses in credit in conjunction with lower asset prices – you should be comfortable enough to nibble on beaten down equities during bouts of volatility. The bashing of the Oil drum gives one reason to consider a dividend aristocrat like Exxon Mobil (NYSE:XOM)), for example. What’s more, the Federal Reserve is highly likely to revert back to “easing talk” over “tightening talk” in 2015, keeping a sharp correction or “baby bear” from turning into a full-fledged disaster.
Still skittish? You could protect any broad market purchase with a decision to sell if your exchange-traded tracker falls below and stays below its long-term (200-day) moving average. For example, selling the iShares Core S&P 500 ETF (ARCA:IVV)) near the start of what became known as the “euro-zone crisis” in 2011 provided enormous peace of mind.
3. Is it wise to ignore signs of amplified exuberance? I don’t believe that it is, no. And neither did John Maynard Keynes who said, “The market can stay irrational longer than you can stay solvent.” If U.S. stock assets can surge for six years with little regard to fundamentals, history or economics – if they can rocket on false premises and unmitigated euphoria – they can also plummet on illogical anxiety and frightful panic.
The solution? You have to have a plan for the eventuality. You might not have believed that oil could fall from $110 to $55 per barrel for a 50% slide in a matter of months, but the commodity is much lower than it was in April just the same. Oil fell from nearly $150 to $30 per barrel in 2008. PowerShares NASDAQ 100 (NASDAQ:QQQ)) fell from $120 to $20 in 2002… the prices of risk assets can and will crater.
Use stop-limit orders or trendlines to raise cash in your accounts. Similarly, employ multi-asset stock hedging by investing in currencies, commodities and debt instruments that do not correlate with stocks. Consider funds like CurrencyShares Japanese Yen Trust (ARCA:FXY), SPDR Gold Trust (ARCA:GLD) as well as iShares 10-20 Year Treasury Bond ETF (NYSE:TLH) in your multi-asset hedging endeavors. Similarly, you might choose to emulate the index that I created for FTSE-Russell, the FTSE Custom Multi-Asset Stock Hedge Index.
Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.