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January 31, 2015

How Do You Assess Market’s Risks and Rewards?

Though I don’t put much weight on forecasts and I invest for the long term, I do keep an eye on how attractive or risky the market appears to be. Partially, I do this because I work in the investment industry and am periodically asked what I think about the market. But I also do this because I think an awareness of the current market conditions can help with portfolio decisions.
None of this is about market timing. Market timing involves buying and selling securities based on what you think will happen. While I have spoken to some investors who say they avoided the last bear market, far more have told me that they have missed out on part or most of the current bull market out of fear about what they thought might happen. I don’t think investors, individual or institutional, should use market timing strategies, and the reason is simple: The future typically unfolds in ways we do not expect it to.
What paying attention to the market’s potential rewards and risks can do is assist you with your portfolio decisions. During periods of greater risk, it can make sense to ensure your portfolio does not have an excessive allocation to overvalued asset classes (relative to your long-term strategy), to tighten your sell rules, and to avoid riskier or more aggressive strategies and investments. During periods of greater potential reward, it can make sense to boost your allocations to the undervalued asset classes (again, relative to your long-term strategy), to be more willing to put up with short-term price volatility in exchange for long-term gains, and to act in a manner that may be contrary to how your emotions may want to you to act (e.g., buying stocks in February 2009). The goal is not to time the market or try to determine when to get in or out of certain asset classes (e.g., stocks), but rather to move within the boundaries of your long-term investment strategy. Even disciplined strategies can allow for some flexibility as long as you don’t violate the spirit or the key underlying premise of your approach.
With this background in mind, here are a few indicators I keep an eye on. This is not meant to be a comprehensive list, but rather some factors, in alphabetical order, you may find useful.
Economic Data: Broad changes in the economy can make conditions more favorable or more troublesome for various asset classes. The challenge is that the financial markets can move in anticipation of a change in the economic backdrop. Thus, though it is tempting to rely on economic data to make portfolio decisions, making correct calls based on the prevailing data is difficult. Evidence of this can be seen in the routinely incorrect forecasts about when the Federal Reserve will start raising interest rates.
One notable indicator may be housing starts. All six of the past market tops (starting in 1973) have coincided with a year-over-year decline in housing starts, according to Sam Stovall at S&P Capital IQ. Housing starts were increasing on a year-over-year basis during the 1961, 1966 and 1968 market tops, so the data cannot be viewed as a flawless indicator of an impending drop in stock prices.
Enthusiasm: One characteristic of a bubble is when expectations of good long-term returns are high and prevalent. Consider the tech bubble of the late 1990s and last decade’s housing bubble. I heard many people talk about rising prices and what great investments tech stocks and real estate were, respectively. Even more recently, the fringe currency bitcoin made many headlines before crashing in price. When enthusiasm is high, valuations often are as well. Conversely, when everybody seems worried about losing their shirt (as they were near the end of the last bear market), opportunities abound.
It’s difficult to fully measure enthusiasm. Our Sentiment Survey gives some insight, as do other similar surveys such as the Investors Intelligence U.S. Advisors’ Sentiment Report. I pay attention to the conversations I have with members, friends and investment professionals. What the media discusses is also helpful. Right now, I still don’t view the current bull market as having a high level of enthusiasm.
Seasonal Trends: Since World War II, stocks have performed better between November and April then they have between May and October. I use these seasonal shifts to see if rebalancing is needed, though the changes can be also used as a prompt to switch between being more aggressive and more conservative. I’m also eyeing how the market ends this month. While the S&P 500’s performance in January does not cause the full-year return for stocks to be up or down, the odds for a good year are higher when the large-cap index ends January with a gain.
Stock Screens: The more than 60 stock screens tracked on AAII.com collectively provide insight into prevailing market conditions. For instance, last year was tough for active managers, and the performance for many of our screens lagged. I can’t say that I’ve noticed a strong correlation between the number of passing stocks for certain screens and the market direction, but I do notice trends.
For example, it’s been tough to find good value stocks over the past several months. Due to the length of the current bull market, many stocks are trading at higher valuations, especially relative to the average valuation ratios that investors have been willing to pay over the past five years. Many stocks are simply no longer cheap. They’re not necessarily expensive, but they’re not cheap either.
Technical Analysis: I am not a chartist, but I do think charts are useful for determining whether momentum is favorable or unfavorable. A significant change in momentum can be a sign that something positive or negative has happened and would be reason to investigate further. From a big-picture view (and ignoring security-specific analysis), combining chart patterns with fundamental characteristics like valuations can be used as a prompt to become more aggressive or more conservative.
For example, the S&P 500 has experienced an up-and-down month and has tested the lows set in December. Even with the fluctuations, however, the index remains above its 200-day moving average, which is a positive. I view the current trend as remaining bullish overall with the recent up-and-down movement being more of a normal fluctuation than anything else. Charts are, of course, open to interpretation, and the opinions of others may differ.
Valuations: Valuations are a useful long-term investment tool. The sharp rise in technology stock prices in the late 1990s and the jump in housing prices last decade were both followed by significant drops. Valuations matter because the higher they are, the more room for disappointment there is. Put another way, valuations reflect the returns investors “expect” to get (high valuations = high expectations) and the returns they “should” anticipate realizing (high valuations = greater chance for disappointing returns).
Right now, large-cap stocks look neither cheap nor expensive. Thomson Reuters lists the trailing price-earnings ratio for the S&P 500 as being 16.9. Some argue that Robert Shiller’s cyclically adjusted price-earnings (CAPE) ratio of 26.7 implies that stocks are overvalued. In the new third edition of Shiller’s “Irrational Exuberance” (Princeton University Press, 2015), there is a chart showing that since 1986, the majority of January CAPE readings above 20 have been followed by market gains over the following 10 years. Three notable exceptions are CAPE readings above 35, which occurred in January 1999, January 2000 and January 2001.
Again, keep in mind that this is not meant to be a definitive list. It is merely some of the indicators I look at. More importantly, understand that none of these indicators will tell you with any certainty what Mr. Market will do next week, next month or next year. Trying to react to each anticipated market move not only increases your transaction costs, but also raises the risk of making the wrong decision at the wrong time, including the abandonment of a long-term allocation strategy out of fear of losing money over the short term. It’s not uncommon for the financial decisions that feel the most comfortable in the moment to end up causing long-term harm to your net worth.
The Week Ahead

About 100 S&P 500 member companies will report their quarterly (and annual) results as earnings season stays busy. Included in this group are Dow Jones industrial components Exxon Mobil Corp. (XOM) on Monday, Walt Disney Co. (DIS) on Tuesday and Merck & Co. (MRK) on Wednesday.
The week’s first economic reports will be December personal income and spending, the January ISM manufacturing index, the January PMI manufacturing index and December construction spending, all of which will be released on Monday. Tuesday will feature December factory orders. The January ADP Employment Report and the January ISM non-manufacturing index will be released on Wednesday. Thursday will feature December international trade data and fourth-quarter productivity data. The January jobs report, including the change in non-farm payrolls and the unemployment rate, will be released on Friday.
Several Federal Reserve officials are scheduled to make public appearances, as is typical following a Federal Open Market Committee meeting. St. Louis president James Bullard and Minneapolis president Narayana Kocherlakota will speak on Tuesday. Cleveland president Loretta Mester will speak on Wednesday. Boston president Eric Rosengren will speak on Thursday. Atlanta president Dennis Lockhart will speak on Friday.
About The Author - Charles Rotblut, CFA is  the VP and Editor for American Association of Individual Investors (AAII).  Charles is also the author of Better Good than Lucky.  (EconMatters author archive here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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