Global stock markets are on life support from central banks. The market is topping.
The next significant market move (30% or more) will almost surely be down. When that will happen is anyone’s guess, this year, next year or…? We are getting closer. The start of this year is similar to prior years; economic numbers start to look bad, then appear less bad and on and on. We may see the market break new highs and signal an all-clear before trouble starts.
The market is greater than 50% overvalued (please see our quarterly market update posting). This is where a lot of money is lost and won. Review your portfolio to make sure your plan can survive a portfolio loss of 50%. A 50% loss would be a run-of-the-mill market loss from the current market over-valuation. The market experienced a greater than 50% loss in 2000-2003 and 2007-2009.
A quick way to calculate how much money you will lose in a hypothetical 50% market loss is to multiply 50% times the amount stocks you own, both domestic and international. For example, if you have a $500,000 portfolio that holds 60% stocks, the loss would be $150,000 ($500,000 x 60% x 50% = $150,000). Your portfolio value would drop to $350,000. This calculation assumes that the non-stock investments in your portfolio would not gain or lose value. A well-diversified portfolio should contain high quality bonds (e.g. U.S. Treasuries) to act as a hedge against your stocks. I recommend the book Unconventional Success by David Swensen, the portfolio manager for Yale’s endowment fund. This book explains the concept of holding high quality bonds that act as a buffer against stock losses. The problem is that currently many bond funds have increased their ownership of poor quality or junk bonds in order to increase interest income in this low interest rate environment. These low quality bonds tend to lose value when stocks lose value so they increase portfolio losses when stocks go down.
Review your portfolio’s stock allocation and the quality of your bond portfolio now before there is a significant market correction.
Use the math sample above to calculate possible losses. You can also go to www.Morninstar.com and view how much your stock or mutual fund lost in 2008. The losses in 2008 were only approximately 70% of the loss from 2007-2009.
Items of note:
- Corporate earnings are decreasing – FactSet notes that current earnings estimates for S&P 500 for the first quarter of 2016 will show the first year-over-year decrease in earnings since 2009 (please see the graph below showing 4 quarters of “Actual” earnings decrease). The year 2009 was the end of the last recession. As corporate earnings goes, the stock market goes.
- U.S. Treasury bonds have been increasing or stable during the recent stock market rally. This does not support a continued stock market rally. Generally Treasuries lose value when investors are in a risky mood bidding up stocks. Between the stock market and bond market, the bond market is generally correct and the bond market is suggesting trouble ahead.
- The bulls and bears are fighting it out. The bulls have not been able to push the market higher; they have hit resistance at the current level. Recent volume has been more tepid on both up and down days which depicts a lack of conviction or trend.
- The S&P 500 has been grinding up and down in a trading range over the last year. On April 9, 2015 the value of the S&P 500 was 2091.18. The value was 2047.60 one year later on April 8, 2016, -2.08% for one year.
- This is the third longest running market advance in history. It is due for a correction.
- Diversification with high-quality bonds won’t mitigate losses during the next stock market correction. Bonds are also significantly overpriced. Bond interest rates are at decade lows and bond prices are at decade highs. Due to the rock bottom low interest rates, bond values cannot move far enough to offset stock losses (High Quality Bonds will be a Risk Asset).
- Please note that low quality bonds move down in price along with stocks (correlated) so these bonds exacerbate losses in your portfolio. Think back to the fall of 2008 and how low quality bonds performed. They tanked. Low quality bonds have been losing value over the last year along with stocks.
- This is the second most overvalued stock market in history. The overvaluation is greater than in 2007 and 1929. Highly overvalued stocks are predictive of a market correction to lower values. When the market will correct is the unknown. Overvalued markets can remain overvalued for a long time but it appears we may be at the top. Time will tell.
- The market is over 50% overvalued. A 50% correction from a highly overvalued stock market is NORMAL. The S&P 500 lost over 50% in 2000-2003 and 2007-2009.
We will take the evidence as it presents itself. This market may have another advance left in it, however, there are very strong head winds. Despite the goodies that the U.S., European and Japanese Central Banks are providing the markets, the party may be coming to a close.
I think they are flicking the lights for last call!
