In an era where stock market valuations have reached their highest levels in over 15 years by some measures, many investors wonder what to do next when looking at their investments in their favorite free portfolio tracker. They ask questions, such as “Should I stay in the market or sit on the bench?” or “How can I protect my portfolio from violet market slides?”
In this article we explore four key options available to private long-term investors to navigate the current market backdrop.
The market has reached valuation levels not seen in many years.
The rapid rise in interest rates during the past year has completely changed the backdrop for long-term investing after many years of ultra-low rates. It’s a environment that seasoned investors have not seen in a long time and many younger investors are completely unfamiliar with. Yet, it is crucial that market participants understand the basics of market cycles. Furthermore, prudent long-term investing requires keeping an eye on the most important market valuation measures both at the market and portfolio level, which is very much facilitated by today’s free portfolio trackers.
Market Valuation Measure 1 – Equity Risk Premium
The empirical evidence is overwhelming. The stock market currently is expensive. In the course of this year, the S&P 500 equity risk premium has fallen to below 4%, a level last seen in 2007. Equity risk premium is as simple a concept as it is important. It reflects the return or earnings yield offered by the equities market over and above the risk-free rate of return. Earnings yield is simply the inverse of the Price-to-Earnings ratio – net profit divided by market cap, meaning it reflects the return (net profit) relative to a company’s market valuation.
A 4% equity risk premium therefore implies that the extra return you can expect to receive on equities exceeds the 10-year Treasury yield, the risk-free rate, by merely 4%. As the chart below shows, the equity risk premium was still well above 5% last year and at or above 6% for most of the time since the great financial crisis.
For some investors this may beg the question: “Is it really worth taking on equity risk, when equities will earn them “only” 4% more than a zero risk investment?”
Market Valuation Measure 2 – The Shiller 10-year CAPE Ratio
Created by Nobel Laureate Robert Shiller, the S&P 500 Shiller CAPE ratio is another widely respected market valuation indicator. It is defined as the ratio of the S&P 500’s current price divided by the 10-year moving average of inflation-adjusted earnings. CAPE stands for Cyclically adjusted Price-to-Earnings ratio.
Unlike the standard P/E ratio, which uses earnings from the last 12 months, the Shiller P/E uses the average inflation-adjusted earnings over the last 10 years. This helps to smooth out market fluctuations (Think Covid stimulus and helicopter money), and gives a more accurate picture of a market’s valuation.
As the chart below shows, equities valuations are at a level that was reached only on rare occasions going back all the way to 1880.
Source: Multpl
So what do to? What are the options?
The good news is that there are good options. The bad news? There’s no golden bullet. Every investor must choose the best option depending on their individual situation.
We have identified four potential options for self-directed investors how to position themselves in expensive stock market setting:
1/ Cashing out
The “Cashing out” option consists of liquidating one’s portfolio and waiting for the market to come down. We believe this would be a mistake for most investors.
Selling out now and buying back in later will come with significant transaction cost – these are real, even if your broker will tell you that trades are free.
If you have already put in the time to build a well-diversified portfolio at your broker or using a free portfolio tracker, you will have to put in the effort again when going back into the market.
And finally, timing the market just right is about as likely as finding the holy grail.
2/ Re-balance: Find high yield plays with Ziggma’s free stock screener
An attractive option to reduce portfolio risk may consist of selling some of your lower conviction holdings and using the proceeds to lock in high yields from fixed income assets. If you need help forming an opinion on the prospects of your stock holdings, you may find the Ziggma Stock Score in the Portfolio Overview table very helpful. It reflects a stock’s prospects versus its industry peers on a scale of 0-100.
Once you have freed up cash, you have the opportunity to lock in yields of up to 7% from a variety of ETFs that invest in bonds. The following table highlights some high-yielding liquid ETFs issued by large, trustworthy counterparties.
How to identify inexpensive, high-yielding bond ETFs in the free stock screener.
3/ Hedge your downside risk
A better alternative to liquidating your portfolio in the face of lofty valuations consists of hedging all or part of your portfolio. To this end, sophisticated investors tend to employ put options and then monitor their portfolios through in-house stock portfolio tracker software.
A simpler option consists of buying the ProShares Short S&P500 ETF. Its objective is to return the inverse (-1x) of the daily performance of the S&P 500. When the S&P 500 index falls, the ETF is designed to rise in value by the same relative magnitude, offsetting losses in a portfolio. The closer your portfolio Beta is to 1 (beta is the correlation factor to the S&P 500), the more suitable the ProShares Short S&P500 ETF will be for your portfolio.
With an expense ratio of 0.9%, there is a cost associated with buying this type of protection. There is also a slight tracking error that will add to the cost of this hedge. By way of illustration, over the past 5 years, the total drift – expense ratio plus tracking error – was around 7% or 1.4% per year (S&P500 +57% vs. ProShares Short S&P500 ETF -50%).
4/ Special cases: Activist investing
Certain investment approaches can bring upside potential to a portfolio that is uncorrelated with the general market. Activist investing is a case in point. Activist investors take stakes in companies in which they have identified certain areas of underperformance or under-valuation. They then work with management in order to resolve the issue and remove the valuation discount attributed by the market. Examples are spin-offs, cost-cutting, senior management changes, and the list goes on.
For instance, Elliott Management, a very successful, high-profile activist investor, is currently engaging and working with Pinterest, to “improve operations”.
Through Ziggma’s guru portfolio, you can view the top positions held by some of the most successful activist investors of our time. This insight enables you to “co-invest” alongside these activist investors. There are two important aspects to consider when pursuing this approach:
1/ Research when the investor initiated the position to make sure that they haven’t already made a fortune and are ready to sell. Generally, these positions are held for several quarters if not years, however.
2/ Making highly concentrated bets is part of these investors’ business model. As a private investor, it is important to maintain a well-diversified portfolio, however.
Staying in control with the help of a stock portfolio tracker
Investing in a market characterized by high overall valuations necessitates caution and skillful navigation.
In this article we have described some of the options available to private investors to reduce the potential impact of a major stock market downturn on their portfolio.
Utilizing Ziggma features, such as our free stock screener or model (guru) portfolios can help investors quickly identify great opportunities to de-risk their portfolios.
Meanwhile, our free portfolio tracker can help you manage risk through proper asset allocation and diversification.
The right tools can not only help you survive but thrive, even in a market landscape that seems overwhelmingly expensive.
Important disclosure: This article is for information only. It is not investment advice. We do not receive any compensation from any of the ETF issuers mentioned in this article.