Sat Dec 31, 2016 10:20 am
Approaching The Current Market Risk Reward Puzzle
A recent Wall Street Journal article raised the question of whether investors looking to get into the market now are too late for the Dow 20,000 party. Many investors watched the 7-year stock bull market from the side-lines after they got burned during the latest financial crisis and didn’t overcome their anxiety and invest again. The article suggested that investing now is a good thing to do if you are a long-term investor.
- Rebalancing your portfolio between sectors and markets should lower your risks and increase your returns in 2017.
- 2016 is an excellent example of how such a strategy works when the general stock market is overvalued.
- Things like avoiding REITs in August 2016 or entering metals will be easy to spot and act upon, even in 2017.
The long-term investor “don’t worry and invest for the long term” clause carefully marketed by financial advisors in order to protect themselves from the downside risks the current stock market holds.
I believe such an approach is exactly the buying high selling low mentality that gives a bad reputation to investing in stocks. If you didn’t invest in stocks in the last seven years, the last thing you should do is invest now that the S&P 500 is up 200% from its lows. What the stock market offers you now is double the risk for half of the returns.
Investors that have been invested in the last 7 years should also understand the above risk reward puzzle. Therefore, whether you are an investor looking to just get in on the market or one sitting on 200% gains, it’s time to do something a bit different than what everybody is advising you to do.
Long term investing is based on the assumption that stocks go up and that even if a bear market comes along, you have nothing to worry about because eventually the market will return to, and surpass current levels. This is completely correct, however such an approach implies that you should stay put and look at your portfolio getting halved in a bear market, like in 2001 and 2008.
The reason why I emphasize on the possibility of a bear market is because the U.S. economy is already 91 months into a positive economic cycle. Simple economic cyclicality laws tell us that it’s clear a recession and a bear market are near as the credit cycle tightens and the weeds in the economy need to be rooted out.
Additionally, the stock market is historically overvalued due to the long period of lower interest rates that has increased investors’ risk appetite. To invest now means investing in one of the most expensive markets in history.
The above chart is essential for understanding the risk of the current market. Most investing theories have been developed on much lower stock valuations and we don’t have many historic precedents for current market valuations to look to to know exactly what will happen. We just know that returns coming from earnings are low while stock prices are high.
The last two years are an excellent example of what can be done to limit your risks while improving potential returns.
In the last two years, the S&P 500 index has been up 8.2% or 4% per year. This is perfectly in line with the earnings yield of around 4% coming from the average S&P 500 PE ratio of 22.75 for the last two years. Therefore, given the current PE ratio of 26.04, if all goes well, you can expect a return of around 4% in the next few years. However, if things change for the worse, the market will be hit hard and quickly decline.
Three market corrections in the last two years show how swift and unannounced market downturns are.
Fortunately for investors, these market corrections didn’t turn into a bear market. Given that the economy is doing extremely well, employment is stable, and the consumer confidence index is positive, it’s very likely that there will be more market corrections in the next few years without negative consequences. Those market corrections offer a great opportunity to trade or to invest at cheaper than current levels, lowering your risk, and increasing potential returns.
Simple news stories, like the latest coming from China where President Xi stated that slower growth for China is a good thing, can send shockwaves around the world and offer you great entry points.
Apart from China, Europe is also always a source of bad news. Volatility is what allows traders to reach heathy returns in all market conditions. Given that China is slowing down, the FED is supposed to raise interest rates three times in 2017, and Europe is always Europe, there is a high probability of increased market volatility which is good for trading and not so good for long term investing. Even better trading opportunities can be found in various sectors, from oil and commodities to pharma and REITs, or emerging markets.
By trading the current market, sectors, or stocks, I don’t mean keeping a constant eye on your portfolio and day trading. I do however consider trading portfolio rebalancing, like buying Apple under $100 or simply not investing in the general market at all.
I’ve written in the past about sectors that offer a good opportunity to rebalance. A few examples that would have allowed you to rebalance your portfolio and beat the market were our zinc supply deficit article back in June, our explanation of why REITs are dangerous with rising interest rates in August, and the call that bank stocks would see higher prices due to their low valuations and increasing interest rates.
So, it isn’t about doing crazy trades leveraging your portfolio, it’s just about doing a few smart things to lower your risks and increase your returns.
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