A Safety-First Strategy

06/10/2016 9:00 am EST

Focus: STOCKS

James Stack

President, Stack Financial Management

Any investment strategy today must allow for the fact that we’re in the 8th year of the second longest bull market in Wall Street history, cautions Jim Stack, money manager and editor of InvesTech Market Analyst.

In addition, and this economic recovery — now at 7-years-old — is also very mature at almost twice the average duration of economic recoveries over the past century.

One very persistent storm cloud that continues to hold our attention is that US stocks — in general — are not cheap. We looked at almost 90 years of S&P 500 valuation data, based on the P/E ratio using trailing 4-quarter earnings.

Currently trading at a P/E of 24.3, the S&P 500 Index is about 30% overvalued compared to its long-term average of 17.1, and has been residing in this elevated valuation range since last year’s market peak in May.

Overvaluation alone does not cause a bear market, but it is a barometer of risk and reflects the absence of a “margin of safety.” This is especially important if making new stock purchases today.

Whether or not this bull market has seen its high, current valuations are significantly greater than at levels of past market peaks. The S&P 500 holds a higher valuation today than at all but one of the previous market tops.

Furthermore, as the Tech Bubble of the late ’90s proved, overpriced markets can continue to move higher, but this only increases the risk when the bull market starts to unravel.
Historically, data confirms that higher P/E ratios almost always lead to deeper bear markets.

The economically-sensitive Dow Jones Transportation Average and the Russell 2000 Small Cap Index are struggling to recover along with the blue chip averages. The Dow Jones Industrial Average is very near a new high.

However, the DJ Transportation Average and premier small-cap Russell 2000 Index have recouped significantly less of their 26-28% loss, and still appear to be diverging in a longer-term downtrend.

There have been only three corrections in the past 35 years in which the Transports and Russell 2000 fell over 20% and the blue chip indexes didn’t experience a bear market: the 1983-84 correction, the 1998 Asian Financial Crisis, and the 2011 correction.

In ten other instances, full-scale bear markets ensued. As such, we are not entirely comforted simply because of the strength in the blue chip DJIA and S&P 500 — and advise continued respect for potential market risk.

If evidence confirms more upside potential ahead, we will be treating it as an additional leg to a very mature bull market, rather than the start of a new bull market.

This is only prudent given our risk management philosophy. There is still a bear market lurking out there, and rising volatility all but guarantees it will be a nasty one.

New additions to our portfolio, if any, will continue to steer toward more defensive sectors that have historically proven resilient to the early stages of a bear market. We’re seeking “safe” profits, not “maximum” profits.

And finally, we will maintain a higher than normal cash buffer due to the age and elevated valuations of this mature bull market.

If we make a mistake at this delicate stage of the economic and market cycle, we strongly prefer it to be on the side of excess caution.

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By Jim Stack, Editor of InvesTech Market Analyst

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