After making their final rate hike in July of last year, the Federal Reserve felt confident that their plan to reduce inflation was on track, notes Jim Stack, "safety-first" money manager and editor of InvesTech Research.
Since then, inflation has continued its downward trend, but has proven quite stubborn. Today, inflation still remains far from the Fed’s 2.0% target. Not only that, but both the headline and core numbers have picked up again over the last couple of months, making the path to rate cuts more elusive.
Currently, just 2 rate cuts are expected this year, with the first not occurring until September. In addition, there is even some discussion among FOMC governors of the potential for no easing at all this year.
Meanwhile, valuations are at some of the most expensive levels in history based on nearly every measure. This poses a major challenge to investors and emphasizes the overarching risk today. While these extremes alone don’t cause bear markets, they are important because they can help gauge the potential losses when the next bear market strikes.
One of the most commonly used — and at times most distorted — valuation metrics for the stock market is the S&P 500 Price-to-Earnings (P/E) ratio. It is popular in the media, and particularly among analysts, to substitute “forward-looking” earnings to make stock prices appear reasonable near extreme overvaluation peaks.
That inherently gives a false sense of valuation security to unsuspecting investors at some of the most dangerous times. Of course, when a recession hits, those forward-looking earnings along with some or most of “current” earnings disappear as companies struggle to maintain sales and fix bloated balance sheet debt.
Meanwhile, the Price-to-Sales (P/S) ratio is effective as a valuation indicator because, unlike earnings, sales are less subject to accounting adjustments or manipulations, making it particularly reliable. The current P/S ratio for the S&P 500 Index is 2.8, which is one of its highest readings since 1990 and is almost 80% above its long-term average.
Stock Market Capitalization-to-GDP, commonly known as the Buffett Indicator, simply compares the value of the entire U.S. stock market to the total value of the U.S. economy. This ratio is more than 150% above its long-term average.
Stocks can remain expensive for extended periods, and a washout is ultimately required to reverse valuation extremes. Yet, despite the overvaluation in the S&P 500 Index, which is dominated by large-cap stocks, there are areas that remain relatively attractive, particularly in the more defensive sectors.
The challenge for investors today is to strategically manage risk by focusing on these pockets of value to protect and grow capital in preparation for the next great buying opportunity when it arrives.
A high level of uncertainty surrounds today’s overvalued stock market and potential housing bubble, which is a glaring reminder that risk management has seldom (if ever) been more important. In addition, speculative exuberance is evaporating in a number of key areas like AI, cryptocurrencies, and even homebuilders. In the past, such reversals in speculation have characteristically led to a broad downturn or selloff.
In this market, all risk is not created equal. While the S&P 500 Index is historically expensive today by virtually all major valuation metrics, some segments of the market are more problematic than others. The Index’s Technology sector currently trades at a stratospheric Price-to-Sales ratio that is only rivaled by the peak in the 2000 Tech Bubble.
Even more dangerous is how concentrated the market is in this sector, where Technology comprises almost 30% of the Index. This figure would be even higher if it weren’t for reclassifications that moved some technology stocks into other sectors. The only time in history the Technology sector has made up more than 30% of the S&P 500 Index’s composition was during the Tech Bubble of the late 1990s.
Managing risk today requires a multi-step approach.
- Avoid or reduce exposure in higher-risk sectors, such as those noted above.
- Consider a heavier weight in defensive sectors and ETFs such as Health Care Select Sector SPDR (XLV), Consumer Staples Select Sector SPDR (XLE), and ProShares S&P Dividends Aristocrats (NOBL) until recession warning flags subside.
- Carry a comfortable cash reserve by focusing on safety and yield, preferably Treasuries.
To protect your hard-earned assets, focus on a strategy that can benefit from unique opportunities but also remain defensive as you wait for a safer (and better) buying opportunity, which invariably lies ahead.
