Many anticipate the rally may still have legs as U.S. markets have push toward new record heights, but this does not mean that there aren’t any risks that could cause stocks to wobble. Alternatively, investors may consider a dynamic exchange traded fund strategy that can adapt to changing market conditions and mitigate downside risks.
Ned Davis Research argued that buying stocks when they are this expensive has historically led to lower future returns, CNBC reported.
The S&P 500′s price-to-earnings ratio was sitting at around 21.5 on a GAAP basis, or well into its historical top quintile. The benchmark’s median return over the past decade when valuations were so high was only 4.7% after adjusting for inflation. In comparison, the S&P 500′s median returns when valuations were at lower quintiles ranged between 5.4% to 11.6%.
Ned Davis warned that with the S&P 500′s absolute valuation currently trading so high, investors should be more cautious.
“Absolute valuations have done a better job than relative ones of identifying stocks as cheap or expensive in the long run,” Ed Clissold, chief U.S. strategist at Ned Davis Research Group, wrote in a note.
After a strong gain this year, “few would be surprised to see that stocks are expensive,” Clissold added. But “if stocks are so expensive, should investors put their money elsewhere? Central banks have left few options in the fixed income asset class.”
The equity and fixed-income markets have strengthened on prospects the Federal Reserve will cut interest rates as soon as next week. The yields on benchmark 10-year Treasury notes have declined almost 60 basis points and broke below 2% in the past six months while the S&P 500 has rallied over 14% in that period.
“For that reason, relative valuations provide a starkly different picture than absolute ones. Comparing the S&P 500 GAAP earnings yield (inverse of the P/E ratio) to the 10-year Treasury yield, stocks are in the cheapest quintile versus T-notes historically,” Clissold said.
If investors are worried about risks in a pricey market, one can look to the dynamic VanEck Vectors NDR CMG Long/Flat Allocation ETF (NYSEArca: LFEQ). LFEQ provides investors with an investment solution that offers a systematic approach to preserve capital by increasing cash when market health is weak and participating in uptrends with a full allocation to equities when the markets are strong.
LFEQ tries to reflect the performance of the Ned Davis Research CMG US Large Cap Long/Flat Index, which follows trade signals that dictates the portfolio’s equity allocation ranging from 100% fully invested or “long” S&P 500 exposure to 100% in cash or “flat” Solactive 13-week U.S. T-Bills.
The index’s model follows a two-step process. The first step measures trend following and mean reversion within the S&P 500 industry groupings to determine a bullish or bearish market environment. Additionally, the model applies a risk filter process to ensure that all of the price-based industry level indicators are effective over time.
The second step calculates the scores taken from the first phase to produce the equity allocations of the index. When the index is not completely long or flat, either 80% or 40% of the portfolio will be allocated to the S&P 500, with the remainder allocated to the Solactive 13-week U.S. T-bill Index.
For more investing trends, visit ETFtrends.com.