October 10, 2017
Recently Published Articles:
- 5 Rock-Solid Blue Chip Dividend Stocks I’m Bullish On
- Medallion Signature Guarantees 101
- International Stocks: A Smart Investment Approach for 2017
How to Deal with High Equity Valuations
It’s important to look at and compare several different types of valuation metrics, because each one has their own little shortcomings. When you compare them together, it makes things pretty clear.
The cyclically-adjusted price-to-earnings (CAPE) ratio of the S&P 500 has now hit over 31, which puts it at near-record highs. It now matches the peak it hit in 1929 shortly before the massive crash, and is only exceeded by the Dotcom Bubble in 1998-2001. Not great company to be in.
Another key valuation metric is the ratio of market capitalization (price of all stocks combined) to GDP, which is best described in this chart, which shows how far ahead the market has gone in just the last few years, and how current valuations are far worse than at the previous market peak in 2007:
Source: Guru Focus
Lastly, yet another interesting metric is the percentage of household financial assets that consist of equities.
During market peaks, equities tend to make up a larger share of household wealth. As Mark Hulbert from Marketwatch explains:
Currently, according to Ned Davis Research, stocks represent 40% of total household financial assets, much higher than the 28.2% average allocation since 1951. There’s been only one other occasion since 1951 in which stock allocation was higher than it is today — at the top of the late 1990s internet bubble, when it rose to 47.5%.
Every other major stock market top of the last seven decades, in contrast, occurred when households’ equity allocation was lower than today’s level. At the 2007 stock market top, for example, the allocation peaked at 37.1%.
This is due to two main reasons:
- People get excited and buy more stock when prices are doing well
- People’s existing equity holdings rise faster than other assets
The problem is, these high valuations are partially justified. Warren Buffett, for example, argues that due to interest rates being so low for a decade, it makes sense for stock valuations to be so high.
Historically, the stock market has produced 8+% annual returns over a long period of time. As I pointed out in my CAPE ratio article, a century of research shows that highly valued markets generally result in poor returns over the next 10-20 years, while lowly valued markets generally result in great returns over the next 10-20 years.
However, suppose that a stock market is highly valued, and can only be expected to produce about 4% annual returns over the next decade on average. If bank accounts will give you 1.3% returns and U.S. treasuries will give you 2.3% returns, then people will naturally over-allocate their assets to stocks. Even if equities give relatively bad equity returns, as long as interest rates are so low, investors have little elsewhere to turn for better returns.
I’m certainly not a fan of these high market valuations, and I’ve been warning against them for a while now. Central banks around the world have been propping up many asset classes by keeping interest rates so low.
But there are various ways to make good money even in highly-valued markets.
Recommendation #1: Avoid Black and White Thinking
The majority of investors follow their emotions over reason. They buy when stocks are expensive (like now), but then sell stocks during and after a market crash, when they’re cheap, and therefore miss out on the recovery.
A more reasonable and passive group just sticks to self-balancing index funds, which works well over the long term. It’s hard to go wrong there.
A smaller percentage of investors try to do the opposite and have more equity exposure when stocks are cheap, which is smart. However, they can be prone to black and white thinking sometimes. Some of them pull all their money out of stocks when they’re expensive, for example, waiting for “the big crash”. Some people ask me via email whether this is a good time to invest or not, for example.
The problem is, if you’re always on the lookout for that 30-40% market crash, then you’ll miss out on so many years in a row where the stock market goes up 10-20% or more. If you avoid a 30% market drop in exchange for missing out on a multi-year 50% increase, then you came out behind.
I rarely make sweeping balance changes to my portfolio. A year ago, for example, I was concerned about high valuations. But if I had pulled all my assets out of stocks, I would have missed out on a 15% increase in the S&P 500, as valuations got even higher. For all we know, this bull market could go another 2 years or more, or it could crash next week.
What I do instead, is gradually dial up or dial back exposure to cheap or expensive things. As the U.S. stock market gets more and more expensive, I slowly reduce exposure to U.S. stocks and start allocating a bigger portfolio percentage to international stocks, put-options, precious metals, cash, and so forth. It’s a very gradual process which mostly involves where I put new money rather than shifting around existing holdings.
Market crashes are rare exceptions. In 2009, the opportunity for cheap stocks was so good that I went all-in on equities around March and April 2009, which paid off extremely well. Certainly if I do something like that again, you’ll be the first to know.
But generally speaking, it’s good to avoid major changes. Either stay totally balanced, like in a lifecycle fund, or gradually shift assets to more attractively-valued things, but don’t try to guess when or how much the market will fall, because that’s usually a fool’s game.
And the more you trade, the higher your taxes and trading fees tend to be.
Recommendation #2: International Diversification
Overall, international stocks currently offer a slightly better value than U.S. stocks, in my opinion.
While the U.S. stock market has had a great decade, developed international markets haven’t been so lucky, and emerging markets have had a terrible decade. Their valuations are cheaper.
For more reading on this topic:
- August 2017 Newsletter: Global Investment Opportunities Abound
- International Stocks: A Smart Investment Approach for 2017
One thing I’m not a fan of is pure market-cap weighted international index funds, and especially the heavily-concentrated EAFE funds that are popular. They invest 17-25% of their assets into Japan, a country with a shrinking population.
I prefer a broader, more diversified, less concentrated global investment strategy, and I described some specific opportunities in those linked articles.
Recommendation #3: Consider Alternative Investments
One thing that I and many readers do when stock valuations become high, is to sell cash-secured put options on stocks or ETFs we like, and get paid to wait for a dip.
Similarly, you can sell covered call options on your existing holdings, to generate more income from them.
Read more about them here:
The purpose of both of those strategies is to shift the risk/reward ratio downward. You sacrifice some of your short-term upside potential in exchange for producing better income and having some mild protection against corrections.
Historically, buy-write strategies and similar strategies outperform during highly-valued markets, and underperform during under-valued markets.
Back in 2009, I was buying stock hand over fist without options, because I wanted access to all that upside potential and it’s a more tax-efficient strategy overall. But now, and over the last few years, I’ve been increasing my emphasis on option-selling because markets have gotten so highly valued, and I favor income and capital preservation over the full access to upside potential.
That being said, these strategies still can offer the potential of 10-20% annualized returns.
It’s not as though upside potential is capped too much, and you can tailor your strike prices to match your goals. For example, if you sell in-the-money put options, your upside potential is still quite high, whereas if you sell out-of-the-money ones at lower strike prices, your upside potential is reduced more in exchange for more safety.
Put Option Example:
Union Pacific Corporation, a great railway, currently trades for $113.88/share, with a price-to-earnings ratio of nearly 21.
While it’s not at a great price, I do think it’s a better deal than much of the rest of the market, given its long-term potential, wide economic moat, and recession-resistant business.
I could buy it now, and it would be okay.
But in my opinion a better deal is to sell January 19, 2018 put options on it at a strike price of $110/share. I would receive a premium of $3.25/share up front, in exchange for obligating myself to potentially buy at $110/share.
One of two outcomes would occur:
If the stock stays over $110, the options will expire in January, and I’ll have made approximately a 3% rate of return in 3 months, or around 12% annualized.
Alternatively, if the stock dips to under $110 and stays there around January, I’ll have to buy the shares at $110, while still keeping my $3.25 premium. This means my cost basis when buying the shares would effectively be $106.75 if exercised, a significant discount to the current price of $113.88.
I use OptionWeaver to quickly calculate fair stock valuations and option rates of return. Here’s the example for Union Pacific:
The light green line shows what I mean by shifting your risk/reward profile downward. You make better returns than you would otherwise make in down or flat markets, but if the stock has a sudden surge upward, then the put option strategy underperforms.
This can work for individual stocks or ETFs; any tradeable security with significant volume that has an options market. If you’re a long-term investor that knows what price you’re willing to buy a stock at, selling put options is a great way to enter positions, and covered calls are a great way to generate additional income on existing positions that you know are getting somewhat overvalued.
Benefits to Option-Selling:
- More income
- Less volatility
- Some downside protection
- Solid performance in flat/bearish markets
Drawbacks to Option-Selling:
- Less upside potential
- Tax-inefficient, unless done in retirement accounts
- Requires some hands-on work
You can also see in this article how to use option-selling on gold and silver ETFs if your goal is income and diversification from equities into other asset classes.
Most investors buy gold or silver, physically or in an ETF, for the purpose of speculation or capital preservation. But the strategy outlined in that article instead focuses on income generation and diversification- it lets you get paid to buy silver or gold when they dip in price, and then get paid to wait to sell them at higher prices, and then rinse and repeat.
The outcome is that you’re essentially agnostic to precious metal prices. You buy low, sell high, and get paid income the whole time. I do this for a portion of my assets so that they are partially uncorrelated with equity prices.
Lastly, there are some sectors that are trading at reasonable prices, even if the market as a whole is expensive. Normally I include some stock picks in my newsletters, but yesterday I published a detailed article with five dividend stocks I’m bullish on, so refer to that if you want some ideas.
Many real estate investment trusts, like Ventas, are trading at lower prices today than they were months ago.
Similarly, energy companies are at low prices due to the long-lasting low oil price environment that we’re in, but I’m bullish on Magellan Midstream Partners and Enterprise Products Partners at these prices, since they focus on midstream transportation and are resilient to low energy prices, and offer high yields.
Plus, although tangible real estate has recovered, it’s still not particularly expensive when considering inflation.
Here’s Zillow’s median home price chart during the course of this business cycle:
Due to the low liquidity and low efficiency of real estate, there are many cities in the United States and other countries where buying rental properties will likely give you better long-term returns than the stock market will at current prices if you know what you’re doing.
My Personal Portfolio Updates
In addition to holding a diversified set of automatically re-balancing index funds in my primary retirement account, I hold these investments in my other accounts:
I manage all of my accounts and monitor my net worth by using the free tool from Personal Capital, which makes everything easy.
Changes since the previous newsletter issue:
- My Ventas puts expired profitably, so I sold new ones for a later date. I continue to generate put income from Ventas, waiting for an entry position.
- I bought back my HollyFrontier puts, because HollyFrontier stock went up quite a bit due to Hurricane Harvey damaging refineries and therefore increasing gasoline prices. Most of the value from my puts was already received due to the stock being so far above my strike price, that I closed the position for a large profit.
- I also let my cash position increase naturally from dividends and income by quite a bit.
In the next two weeks, my Discover puts will likely be expiring profitably, and I’ll be selling more to renew the position.
Virtual ETF Portfolio Updates
Each newsletter for fun, I update a virtual ETF portfolio.
It takes about 5 minutes per month to manage, and helps show where I think value is in the market without focusing on individual securities.
You can see the previous version from the August issue here.
For reference, the S&P 500 is at $2544.73 and the S&P 500 TR is at $4940.16.
Changes since the previous issue:
- IDV paid a distribution of $0.260895, so at 700 shares that’s $182.62.
- VWO paid a distribution of $0.522, so at 100 shares that’s $52.20.
- VNQ paid a distribution of $0.854, so at 200 shares that’s $170.80.
- As of today’s current prices, I’m selling 3 cash-secured put contracts for SLV at a strike price of $16 for 1/19/2018, which brings in $55 per contract in premiums or $165 total. This lowers the free cash balance by $4800 and increases the secured cash balance by an equal amount, and is represented in the table.
I plan for the next issue to be in late November.