“I think the public is walking into a trap again as they did in 2007… I think it almost the duty of well-respected investors, like myself I hope, to warn people, to tell people, that you are making errors.”
Related ETF s
This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Steve Blumenthal, chairman and chief executive officer of King of Prussia (greater Philadelphia area), Pennsylvania-based CMG Capital Management.
The market is expensive and the risk is great. You wouldn’t get that impression listening to many Wall Street sell-side analysts. Today let’s take a look at valuation and two simple ideas that may help you navigate the bumpy road ahead.
I scratch my head when I hear an analyst say the stock market is fairly priced since the forward price/earnings multiple (P/E) ratio is “only” 17. The forward P/E was 14.1 at the October 2002 low, and 15.2 at the October 2007 peak, according to a composite of estimates from First Call, Compustat, FactSet and JPMorgan Asset Management as of June 30.
So, what makes 17 such a good value? Frankly, Wall Street analysts have a very bad habit of overestimating forward earnings. To me, forward P/E is an unreliable measurement.
A Better Metric Than Forward P/E
A better valuation measure, I believe, is median P/E. It looks at reported earnings (not forward estimates) and is an approach that limits the impact of special “one-time” write-offs and other accounting gimmicks.
If we were to break all of the monthly median P/E readings since 1984 into five quintiles, today’s median P/E would fall into “quintile 5”; in other words, the most expensive category.
Interestingly, the least expensive quintile—that is, the one with the best value for your investment dollar—produced subsequent 10-year S&P 500 Index gains per year of 15.91 percent. The most expensive quintile produced S&P 500 Index gains of just 2.94 percent over the subsequent 10-year period, according to data from Ned Davis Research as of May 31, 2015.
Translation: Ichan’s warning should not go unheard.
Heed Buffett Too
Warren Buffett is quoted as saying: “When hamburgers go down in price, we sing the "Hallelujah Chorus" in the Buffett household. When hamburgers go up, we weep. For most people, it's the same way with everything in life they’ll be buying—except stocks. When stocks go down and you can get more for your money, people don't like them anymore.”
Let’s just say, in looking at most valuation measures today, it is not the time to sing.
Finding A Way Out
So what is an ETF investor to do? In the following section, I share two tactical trend-based processes that may keep you invested in the assets that are moving up in price. Both measure price momentum to determine trend.
Let’s first take a look at a three-way asset strategy (large-cap stocks, long-term bonds and gold) and then take a look at a simple moving average “stop loss” process that you may apply to most individual securities, including ETFs.
3-Way Asset Strategy (Stocks, Bonds & Gold) 1969 To Present
The concept here is simple, and often simple is best. The assets used in the three-way asset strategy are the S&P 500 Total Return Index for stocks, Barclays Capital Long-Term Treasury Total Return Index for bonds, and Gold Spot for gold.
Here is how it works:
- Stay fully invested in any of the three assets provided each asset’s three-month moving average is above its 10-month moving average. If, for example, gold is the only asset with its three-month price trend above its 10-month, then the model will be 100 percent long gold. If stocks and bonds are above, but not gold, then 50 percent is positioned in each. If all three are in a positive uptrend, then a third is allocated to each. It's that simple. The model’s returns are better and much less volatile than the S&P itself.
The red line in the following chart shows the performance from 1968 to present when holding the asset classes (S&P 500, long-term bonds and gold) when the three-month moving average is above its 10-month moving average.
It also shows how a three-way model can do well against the stock market as represented by the Standard and Poor's 500 Total Return Index. You’ll see that currently the model is allocated 50 percent S&P 500 Index and 50 percent long-term Treasury bonds. Gold has been in a downtrend for some time.
To implement the strategy, there are a number of ETFs that may be used. For equities, consider one of the following cap-weighted S&P
500 Index-based ETFs:
Or you might consider smart-beta S&P 500 Index-based ETFs if you believe they will outperform the traditional cap-weighted approach, such as:
And for long-term Treasury bond exposure, consider:
A strategy such as this might fit along with your other core portfolio holdings. The idea is that it manages downside risk quite well. For your single-ETF holdings, there are ways you may risk-protect those positions as well.
Consider the following:
Price Momentum: A Simple Moving Average Risk Management Process
Price behavior alone can tell us a lot about supply and demand. When there are more buyers than sellers, prices move higher. When selling overpowers buying demand, the price declines.
Imbalances build up—when confidence in the market is gained, investors tend to allocate greater percentages of their investable net worth to stocks. Further, margin is used that allows the more aggressive investor to buy even more stock.
But when the trend changes, margin calls can kick in that result in forced selling and more margin calls. A spiral of selling can occur—such as what happened in the 2000 tech bubble collapse and the 2007 great financial crisis.
We can think it won’t happen again, but it will. Yet, while we can measure the degree of risk, the timing is nearly impossible to predict.
So let’s take a look at several ideas that can help you stay in sync with the primary trend. I do believe you can let the cyclical trend, as they say, “be your friend.”
The chart that follows looks at the S&P 500 Index 50-day moving average price line and compares it with its longer 200-day moving average price line.
Here the trend is identified to be higher when the shorter-term moving average price trend (black line) is higher than the longer-term 200-day moving average price trend (dotted red line). The concept is easy to understand, and you can see the performance results highlighted in yellow.
The Benefits Of Stop-Losses
As I said, overcoming a 50 percent decline requires a 100 percent subsequent return. It also takes years to recover from such losses. Long-term thinking can be emotionally impossible if such a decline happens near retirement. Logic and discipline are tossed aside. It may be equally emotional for the younger investor as well.
Take a look at the chart again. Note how the 50-day over 200-day moving average cross helped one avoid the 2008 market meltdown and also allowed participation in the recovery. That’s the general idea with risk management. There are hundreds of academic studies on price momentum tested many ways and in multiple markets over hundreds of years.
Recall all the great news that was in the press when that 50-day crossed lower in late 2007. Then it was the “Goldilocks Economy” and Greenspan’s “there is no bubble in the housing market,” etc. Price was signaling there was more selling supply than buying demand.
And what about the buy signal in mid-2009? Lehman vanished; Bear Stearns was dismantled; AIG was in free fall; margin debt and all sorts of creative leverage were forced to unwind. We were looking at near collapse of the entire financial system.
Yet in 2009, price was telling us something important. While fear was high, the selling pressure had passed and a new uptrend was underway. An easy-to-follow trend-based process can work. The hard part is finding a process you can follow and sticking to it.
Stick To Your Plan
There are other price-momentum approaches you can incorporate. The point is to find something you have conviction in and, again, stick to it. Something really good happens when you combine a number of diverse but disciplined strategies together in one portfolio.
Whether it’s a 10-week over 40-week trend process or a 50-day over 200-day, the message today is that when valuations are rich and forward return low, the risk imbedded in your portfolio is much greater. Overcoming a 50 percent loss takes a subsequent 100 percent recovery gain, and that also means years of lost earnings potential. And this is just to get back to even. Overcoming a 15 percent decline is much easier to do. It’s for this reason that a risk-management process is so important.
That’s especially true when the hamburgers aren’t cheap.
At the time of writing, the author’s firm owned shares of GLD on behalf of clients. CMG is an ETF strategist specializing in tactical investing, using trend-following and relative-strength-based strategies. CMG Chairman CEO and CIO Stephen Blumenthal also writes for Forbes and speaks on various radio and TV shows. Contact CMG at 610-989-9090 or at firstname.lastname@example.org . Click here to receive his free weekly e-letter. For a list of relevant CMG disclosures, click here .