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 (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 (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 (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 (FXY), SPDR Gold Trust (GLD) as well as iShares 10-20 Year Treasury (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.