Stocks Are Crazy Risky Now - We’ll Reveal The Perfect Hedge

March 5, 2018

Stocks Are Crazy Risky Now – We’ll Reveal The Perfect Hedge

There’s some volatility in the markets that we haven’t seen for a long time.

The increased volatility is a sign of nervousness and the market is looking for direction.

No one knows where things will go in the short term as that’s impossible to know. Even Warren Buffett never fails to mention how he has absolutely no idea about where markets will go in the short to medium term.

If we look at things from a macro perspective, the economy is at its limits and we’ve seen the actual GDP finally reach the potential GDP.

Figure 1: Potential vs. actual GDP. Source: FRED.



When the economy operates at its full potential, it becomes a difficult balancing act for politicians and the FED, and never in history have we seen a soft landing because cyclicality is natural for the economy and for humans in general.

This means that the risks of a recession are pretty high and even Ray Dalio said recently that from his perspective, there’s approximately a 70% chance of a recession by 2020 in an interview with Harvard Kennedy School.

Now, it’s important to look at what the direct risks are for stocks and where the potential rewards can come from. Let’s start with these five risks: the market cycle, interest rates, valuations, earnings, and debt.

The Market Cycles

The S&P 500 was around 100 points back in 1,982 while today it’s at 2,700. What most forget is that markets don’t always go up.

If we look at the inflation adjusted performance of the S&P 500, there have been extremely long periods where markets didn’t go anywhere. From 1929 to 1958, 1954 to 1982, 1968 to 1991, and from 1999 to 2016. Further, if we see the S&P 500 drop 20%, that last period would be even longer.

Figure 2: S&P 500 inflation adjusted returns. Source: Macrotrends.

So there are long term market cycles that people are unaware of because who looks beyond the last few years when analyzing risk? We don’t know how the cycle will evolve, but there is a possibility of very negative returns over the next few decades especially when combined with the following risk factors.

Now, many would counter that dividends contributed to the bulk of returns in the past which I won’t argue against, but I will say that the current dividend yield of stocks is at 1.8%. This leads me to the next risk for stocks, interest rates.

Interest Rates

Interest rates work on asset values like gravity. If we see higher interest rates, sooner or later, they are bound to have an impact on stock prices.

If we look at the following chart of the 10-year Treasury yield and the S&P 500 earnings yield, you can see how over the long term, they move in tandem and that’s what the average investor has to look at.

Figure 3: Interest rates up, stocks down. Source: FRED, Multpl.



So if we see a similar scenario to the 1960s and 1970s with much slower economic growth, higher global competition and lower productivity growth, things could get ugly for stocks. Further, the valuation picture isn’t positive at all.

Valuations

I prefer to look at the cyclically adjusted price to earnings ratio that uses average 10-year earnings to give a valuation metric.

Studies from Professor Jeremy Siegel shows that it explains 33% of future 10-year returns and this is another high risk factor for stocks. If you use common sense and not academic rigor, you’ll see that it’s pretty accurate.

Figure 4: CAPE ratio and subsequent 10 year returns. Source: Financial Analysts Journal – J. Siegel.

Further, the PE ratio of 25 that stocks carry now leads to a 4% to 6% return if things end up being perfect over the next 10 years which is highly unlikely.

Earnings

Staying on the topic of earnings, many focus on them and expect them to continue to grow relentlessly in the future, especially with fiscal stimulus. What I would say to that is that earnings haven’t really grown in the last 10 years and that there is a high likelihood that they won’t grow at all in the next 10 years as earnings are usually at the highest level in the late part of the economic cycle.

Figure 5: S&P 500 earnings. Source: Multpl.

And something to finish with is debt. Few think about it as long as everything grows, but after that it becomes a huge burden on everything, especially with higher interest rates.

Figure 6: Corporate debt has doubled in the last 10 years. Source: FRED.



Higher debt levels aren’t a burden when interest rates are extremely low but when that shifts, you’ll see a lot of pain.

What To Do

The average investor should think about the best hedge out there, cash.

Berkshire and Buffett now have $116 billion in cash on a stock portfolio of $190 billion, that’s 38%.

My message is to think about your cash allocation and why Buffett is holding so much cash in relation to what you hold.

P.S. Be ready to hold that cash for as long as necessary and until a great long term opportunity knocks at your door.



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