Advisors are wondering: What percentage of equity should I hold in my client portfolios? How frothy is this market? Is it time to get more defensive?
The short answers: this market is expensive – stay cautious. Hedge long-term equity exposure.
How do we realize this? On the chart below, the table shows stock market performance six-months to five years after over- or under-valuation is reached.
In the bottom clip, note the S&P’s current price to its Normal Valuation Line (dotted red middle line) and the zones that identify valuations to be “overvalued” or “undervalued”. The yellow circle identifies current valuation. The idea is to get a sense of a market that is above or below its normal valuation. When the S&P 500 is 20% above its normal valuation, we consider it overvalued; at 20% below normal we consider it undervalued.
The chart takes six different measures and combines them into a single valuation (red line) to help give us a feel for how the market is priced relative to its historical norms. Here are the six valuation measures:
Digging a bit deeper if you are a quant geek like me. Historical averages are used to calculate the “normal” valuation in five of the six measures. For example, the average of the monthly historical price to dividend ratio multiplied by the historical dividends per share gives the normal price for each month. The same goes for cash flow, sales, earnings and the CPI-adjusted P/E. The Trend component is a linear regression of the S&P 500 against time. Each month’s data represents the median of the six normalized price lines – four until 1947 and five from there to 1954. I believe it is important to note the amount of history used in these calculations.
In short, if we were in the “undervalued” or “neutral” zones there would be less need to hedge. Given the historically high current valuations, risk is elevated. It is a good time to hedge. Our current tactical portfolio allocation is 30% equities, 30% fixed income, 40% tactical. – Steve Blumenthal