Major Signals Point to Market Top

Investment Risk Mitigation is Prudent Now.

Several valuation and behavioral indicators are signaling that a generational stock market top is forming. While periods of overvaluation can persist, we advise reducing equity exposure in the Magnificent Seven, and capitalization weighted indices like the S&P 500 (SPY) and the NASDAQ 100 (QQQ). Furthermore, we advise reviewing your financial plans and moving out of the popular 60/40 stock bond asset allocation model and into an asset allocation model that is 25% cash, 25% commodities, 25% equities, and 25% bonds. After 42 years of declining 10-year US Treasury yields, recency bias may trap investors in the S&P 500, 10-year US Treasury Notes, and the 60/40 asset allocation based on their exceptionally solid past performance. Because valuations are high and inflation prospects are uncertain, a prolonged period of low single digit performance in large capitalization equities, bonds and the 60/40 asset allocation is probable. Both the 60/40 asset allocation and the S&P 500 could experience a 30% decline and we believe this current speculative and overvalued market is reminiscent of 2021-22 when we wrote “Major Warning Signs Point to Market Top” on August 3^rd, 2021 and “The Market Crack Heard Around the World” on February 3, 2022. There is even greater downside risk in parabolically priced cryptocurrencies, the Magnificent Seven, and NASDAQ 100 index. 

Overvalued Equity Valuation Models:

The Fed Model:

The Fed Model or Risk Premium model turned negative to -0.12%. The Risk Premium compares the earnings yield of the S&P 500 to the 10-year US Treasury yield. This indicator says the S&P 500 is not an attractive risk versus the 10-year US Treasury just as was the case during the 2000 Technology Bubble. The unique value of the Risk Premium model is that it compares the largest equity proxy, the S&P 500, to the largest alternative asset benchmark, the 10-year US Treasury. As such the negative rating shows the S&P 500 to be near historically high valuations compared to all asset classes and the US Treasury market, in particular.

The Buffett Indicator:

The Buffett Indicator or Market Capitalization to GDP indicator also suggests the market is at extended levels and near historical highs correlating with generational market peaks in 1970 and 2000.

The CAPE Ratio:

Nobel Laureate Robert Shiller’s Cyclically Adjusted Price Earnings (CAPE) Ratio also signals that the market’s 10 year PE ratio is quite extended and close to the generational peaks of 1929, 1970 and 2000. The CAPE is currently at 38 and near its peak in 2020 and 2000, and above 1929 and 1970. Each of those previous peaks preceded significant stock market declines or prolonged periods of underperformance.

The high equity market valuations models shown above suggest that future equity market returns are likely to be in the 0-3% range, based on history. The dot plot chart below shows the S&P 500 forward PE multiple plotted against the S&P 500 return in their subsequent 10 years. The higher the forward multiple, the lower the future earnings profile for the next ten years. Furthermore, the chart below suggests that the likely forward ten year return for the S&P 500 will be close to 0-3%. 

This forward PE multiple to future return relationship reinforces the Wall Street saw and wisdom of “buy low, sell high.” However, today, there is a large pool of quantitative investing “momentum money” that is geared to buying stocks that are moving up, even at new highs and historic valuations. This momentum investing has led to this past year’s exceptional returns in the S&P 500 (SPY), the NASDAQ 100 (QQQ), and Magnificent Seven (MAGS) of 25.59%, 27.74%, and 67.7%, respectively. This momentum investing phenomenon and the outsized market returns of the last year underscore the potential investment risk of those who look to past performance as an indicator of future return prospects.

History tells us that we are in a “greater fool” market. The greater fool concept is that investors are so consumed by “FOMO” or “Fear Of Missing Out” that they believe there will be a greater fool who will pay an even higher price for the fundamentally overvalued asset you are buying today.

Historically, as markets move higher, they draw in more investors and create an investment feedback loop that reaffirms their investment rationale because the rise in their investment’s price reaffirms the soundness of their investment logic. This leads to parabolic price appreciation. This feedback loop drives market prices higher, adds to the positive market psychology which draws in further investors. This positive feedback loop continues until valuations hit an extreme, and the upward momentum breaks. Then the positive feedback loop stops, and a negative feedback loop takes hold. 

Behavioral Economics:

Nobel Laureate Robert Shiller’s book Irrational Exuberance provides an historic analysis of human behavior during major market peaks. During such periods, unusual optimism often pervades the national psyche. Today, great expectations around artificial intelligence (AI), the Magnificent Seven, Bitcoin, DOGE (“the Department of Government Efficiency”), inflation reduction, and prospects for peace in Ukraine and Israel are part of the national discourse. When high expectations are priced into security prices, share prices are most vulnerable to decline. Should any of those hopeful expectations fail to materialize, momentum can shift from its current upward trajectory, rollover, and turn down. In fact, share price momentum can transform from a positive feedback loop into a negative feedback loop. The development of a negative share price feedback loop transforms bull markets into bear markets which can lead to a material decline or protracted period of underperformance.

Three protracted periods of disappointing S&P 500 performance following major bull markets occurred from 1929 until 1949, from 1970 until 1981, and from 2000 until 2009. These periods are apt analogues to today’s environment.

Parabolic Price Action:

Parabolic moves end badly. The chart below shows how the 10 largest capitalization stocks have risen from 18% to 40% of the S&P 500 since 2016, and this intense concentration of large cap stocks in the parabolic rise of the S&P 500 suggests meaningful downside risk for the S&P 500 in the years and months ahead.

The Great Rotation:

While today’s concentration of mega cap to the S&P 500 is perilous, it simultaneously suggests a period where long dormant sectors may begin sprouting the green shoots of new bull markets while momentum investors are consumed in today’s investment mania much like 1929 and 2000.

In the years ahead, we see great promise in emerging markets. India, Argentina and more recently China have already rallied. Commodities, like gold and silver, have also been basing and appear to be in new emerging bull markets. Owning either the commodities or miners provides valuable diversification.

Below is a chart, following the 2000 bubble, which shows the out-performance of the emerging and international markets versus the US equity markets. We believe the 2000-2011 period to be a compelling historical analogue to what we expect to unfold in the years ahead.

We advocate moving equity investments from large capitalization equities and reallocating to value investments such as we observe in emerging markets, international markets, commodities, and precious metals in order to prudently mitigate risk and tactically allocate assets.

The chart below by Bank of America shows how the vast majority of equity out-performance has been in the US and dwarfed the performance of the rest of the world by nearly three standard deviations. Historically, capitalizing on extreme valuations has been the source of great wealth generation. For this reason, we believe allocating to international markets and the emerging markets in particular not only derisks a simple 60% large cap equity portfolio but also creates potentially attractive new investment selections to investors overweighted in US equities.

NYU professor Jean van de Walle has produced some excellent CAPE valuation analysis to quantitatively sort through non-US equity markets. The chart below suggest Columbia, Chile, Brazil, Philippines and Korea are deep value international markets with current ratios of 8.8, 9.2, 8.5, 15.2, and 8.0, respectively, and dramatically less expensive than the United States at 36.4!

Financial Planning:

Having a thoughtfully constructed financial plan is fundamental to ensuring our clients have sufficient assets to retire comfortably. With that plan, adjusting asset allocation and tactical asset allocation is critical for long term performance and achieving your investment goals. However, we believe market conditions are ripe for recalibration as traditional asset class performance and expected returns could vary materially from the return performance investors have enjoyed over the last 42 years while interest rates have been declining.

The most important investment planning assumption is the prudence of using of the 60% equity and 40% bond asset allocation. We believe that the 60/40 asset allocation could decline as much as 30%, and this equity heavy strategy could lead to material losses that are far more consequential than most investors or their planners realize.

For the reasons detailed above we feel overweighted US equity portfolios could experience a downside of 30% and far more if you are invested in capitalization weighted indices, the Magnificent 7, or cryptocurrency stocks. A 25% cash, 25% commodity, 25% stock and 25% bond allocation today can offer far lower risk, higher income, and better inflation protection than a 60/40 stock bond allocation. 

In the twenty-teens, massive central bank financial accommodation led to negative interest rates and near zero interest in money markets and short term income securities. Some investment professionals said “cash is trash” and that the market had become a “TINA” or “there is no alternative” equity market. In our opinion, a prudent retirement plan should have 25% in cash or cash equivalents. Furthermore, the 10-year US Treasury yield of 4.57% offers a comparable yield to money markets, and the 4.57% yield does not compensate investors sufficiently for the duration risk of a ten year security. Consequently, a 25% allocation to bonds is more prudent than a 40% allocation to bonds. 

Conclusion:

Valuation indicators are not good market timing instruments; however, they can signal when markets are near extreme under or over-valuations. Through methodical asset reallocation, portfolios can reduce risks when market valuations are overvalued, as they are now, and can increase risk or equity market exposure when valuations are undervalued. Retirement plans and retirement strategies should not be allocated to the 60% equity 40% bond allocation strategy, in our opinion, and contrary to their attractive return history of the last 40 years, the 60/40 strategy is over-valued and the S&P 500 could decline as much as 30% wreaking havoc on the retirement plans of the elderly.

The future is always unknown and today’s challenges with inflation, massive federal debt, dollar strength, geopolitical uncertainty and an overvalued S&P 500 suggest the asset reallocation away from the popular 60/40 stock bond allocation is a critical derisking process retired investors should be deploying today.

While there is clear market vulnerability to market capitalization indices and mega cap stocks, we believe there are attractive opportunities in less popular value markets including small capitalization, value, international, and emerging markets stocks as well as closed end funds, commodities, precious metals and commodity stocks and miners. While our letter and market view is cautionary, we believe that where there is change there is opportunity and we see great opportunities in the years ahead.

Happy New Year!