...up until the party ends, market participants would never consider what Dan has to say here, but when it (party ends) does, they would wish they had.
...there's no place for regret in Investing, 'I could have' in the rear mirror is when we don't actively and consciously decide based on Where We're At.
by Dan Ferris I'm not technically making a prediction...
Today's Digest might seem like I'm predicting the stock market is going to fall by a lot fairly soon.
But what I'm really doing is describing the current market circumstances that indicate a higher level of risk in U.S. stocks today.
By using historical examples of similar circumstances, I'll show that although history might not repeat, it could rhyme enough to make a huge negative difference in your investment results. And then I'll suggest how to prepare for what might come next. I believe that's all we can do.
So let's get started... 'Mom and pop' are more in love with stocks today than at previous market tops...
That includes the dot-com bubble, the most expensive moment in U.S. stock market history.
Goldman Sachs recently published some Federal Reserve data showing that equities now account for 48% of household financial assets, the same level reached in the first quarter of 2000. Those peaks are much higher than any other time since at least 1960.
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In other words, the data Goldman Sachs used from the Federal Reserve shows equity ownership as a percentage of household financial assets is at a 24-year high.
You've likely seen a version of this chart before. But for the life of me I don't know how Goldman Sachs came up with it. I went through the same Fed data and wound up using two other data sets.
The chart I created below has two lines. One shows U.S. household ownership of corporate equities – stocks. The other line includes all types of equity ownership in any type of business and mutual-fund shares.
Both data sets show equity ownership as a percentage of household financial assets isn't just at a 24-year high... it's at a 55-year high. In other words, the Fed data I found shows that U.S. households have more of their financial assets in stocks than at any time since the first quarter of 1969.
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Either way, whether you use Goldman Sachs' chart or mine, investors have more of their financial assets committed to equities than they have in decades. Investors are betting on stocks in the futures market, too...
Using Commodity Futures Trading Commission data, SentimenTrader.com recently reported that small speculators are "all in" on stocks.
That means small, individual investors managing their own futures accounts are buying more S&P 500 Index, Nasdaq Composite Index, Dow Jones Industrial Average, and other equity futures than they have at any time since at least the 1980s. They're so confident that they're holding a winning hand, they've pushed all their chips into the center of the table.
Futures are inherently leveraged bets, requiring only a small deposit relative to the value of each contract. It reminds me of how folks bought stocks on margin during the Roaring '20s – right before it all crashed, ushering in the Great Depression. Again, this isn't a prediction. It might not even be a warning. It's just a bad feeling.
Americans are also confident enough to concentrate their bets in the highest flying names... J.P. Morgan Equity Macro Research recently published data showing that investors are piling into the stocks with the highest upward momentum at a rate matched only at the market tops that preceded the dot-com crash and the great financial crisis of 2008. Folks are convinced that what has gone up a lot already will go up a lot more. The problem is that stocks with ballistic trajectories don't usually correct by going sideways. They correct by plummeting back to Earth. I'll repeat that as often as I need to.
Meanwhile, investors big and small don't seem crazy about holding cash these days. A recent Bank of America report indicated the average Wall Street strategists' cash-allocation recommendation is at its lowest level since at least 2006.
It all makes sense.
Individual and professional investors are only human. When the market makes new highs, they get excited. When they see the gains they've earned, it's only natural to want more. And if they've been too afraid to commit, the market's upward momentum encourages them and fills them with confidence.
Regular Digest readers know I believe we're seeing the biggest financial mega bubble in recorded history. And this sort of hyper confidence in a blistering market performance tends to happen when equities are the least attractive investments.
I've used the cyclically adjusted price-to-earnings (or "CAPE") ratio a few times recently to show how expensive stocks are... as well as to confirm that they've only been this expensive at three previous mega bubble peaks, 1929, 1999, and 2021. But let's look at it another way...
Instead of merely noting how expensive stocks are compared to their historical valuations, let's take a deeper look at that historical performance through the eyes of quantitative investment firm AQR Capital Management's Chief Investment Officer Cliff Asness, who spoke with Barron's recently.
According to Asness, U.S. stocks have performed well because, over the past three decades, investors have been willing to pay higher and higher valuations...
Since the early 1990s, about 80% of the U.S. dominance has come from relative price/earnings multiple expansion versus non-U.S. stocks. People were paying less for the U.S. at the beginning, and now they are paying considerably more. Maybe that is justified; maybe things like U.S. tech dominance are real. But justified doesn't mean repeatable...
Looking to the future, the case that the U.S. will have permanently higher equity returns is pretty untenable. Even if U.S. companies are worth it, they are priced as such.
Asness' last line makes me think of investor and author Howard Marks, who often asks "who doesn't know this fact?" about popular investment ideas. For example, AI is a game-changing technology... but who doesn't already know it? And if everybody knows it, then it's already priced into AI-related stocks.
In a much larger sense, who doesn't think that buying U.S. stocks, especially mega-cap tech stocks, isn't the greatest trade in the world today... the one that you can buy on every dip and make lots of money on?
I'm saying, and I believe Asness would agree, that U.S. stocks can't go to the moon. They're simply too expensive to deliver the higher long-term returns they've delivered over the past few decades. Folks concentrated in U.S. equities are virtually guaranteed to be disappointed with their performance over the next several years.
mce-anchorIt reminds me of the 1970s, when the CAPE ratio of U.S. stocks fell from about 21 in January 1969 to 6.6 in July 1982 mce-anchor– its lowest level since 1932. The market hated inflation and it pushed equity valuations to 50-year lows. Asness didn't say it, but I will. The current moment is ripe for something like that to happen again. I realize my warnings might land flat with the markets marching higher...
That's human nature for you. Folks are the most confident and the least interested in hearing a divergent viewpoint right when they most need to hear it. There's just no way to make folks feel a sense of urgency about a risk when it's nowhere in sight for those folks.
I'm content being the lone voice crying in the wilderness... looking for big risks looming on the horizon, even if some of them never arrive. The trouble is when they do arrive, they're so nasty that everyone wishes they had given them at least a little bit of thought beforehand.
But if you are concerned about the prospect of the extreme underperformance of high-flying U.S. (mostly tech) stocks, you can prepare by doing one thing right now...
Make sure you're holding plenty of cash. How much is up to you, but it seems like an amount equal to at least 20% of your equity portfolio would be a good starting point. Cash serves a dual function. It won't fall in value when your equities do and it's essentially an option that never expires on the future opportunities you'll find most attractive.
Everybody tends to hate cash right before they need it the most. But when stocks are down 20% or more, that isn't the time to start thinking about raising cash. That's when folks who failed to prepare will start panicking and selling like crazy to the calmer, better-prepared folks who gave up a little bit of return in the hyper bull phase so they could take advantage of better pricing during the inevitable decline.
The other asset you should hold is precious metals. Gold and silver have had a solid run lately, but that doesn't mean you shouldn't buy them if you don't own them. I'm also not saying gold will rise if stock prices fall. I'm just saying that you should focus more of your assets on sound stores of value right now because you're likely heavily weighted toward financial assets like stocks... and the most popular stocks aren't attractively priced.
Again, I realize talking about the dangers of expensive markets sounds like a bear market prediction. But I'm just saying that history strongly suggests that the higher an already overvalued market goes, the more certain you can be that it'll correct sharply when it finally breaks.
Now, I'm not foolish enough to try to tell you when that will happen... where the top will be... or where the bottom will be when it's over. A correction might be further in the future than you'd ever guess.
But historically speaking, extremely overvalued moments have all ended one way: with brutal bear markets. Some have been followed by even more brutal sideways markets.
For example, earlier, I showed you data indicating that 1969 was the last time stocks as a percentage of household financial assets were at current levels. Thirteen years of brutal sideways market action featuring several steep declines followed that moment. It's okay to enjoy the money you're making along with everyone else in the market, but it's not a good idea to forget that investing involves risk, and sometimes those risks are bigger than you might imagine.
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[/table] I've been warning folks about the probability of a sideways market for at least two years now. It's no less likely today. In fact, the longer it takes to arrive, the more likely I believe it will happen. In other words, the longer investors drive valuations up too high, as they've been doing for 30-plus years, the more certain we'll see not merely a bull market, but a decade-plus sideways market as well. I'm not telling you to stop buying attractively priced stocks...
It's silly not to buy a good stock priced for a good return just because many other stocks aren't as attractive.
But I'd caution you about buying the stocks everybody loves, like the ultra-popular, ultra-expensive "Magnificent Seven" – Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Alphabet (GOOGL), Nvidia (NVDA), Meta Platforms (META), and Tesla (TSLA). They've dominated the stock market over the past couple of years, at times accounting for nearly 30% of the S&P 500 index.
Though Nvidia and Meta are still flying high, Apple and Tesla have both logged negative returns so far this year, and Google parent Alphabet is up less than 8% as of yesterday's close. So maybe this is the beginning of the end of Magnificent Seven dominance... and perhaps even of the concentrated, leveraged bet so many folks are making on U.S. stocks today. Avoiding the popular stocks will require you to think and act differently...
In the 2014 film Divergent, people who didn't fit into one of society's approved classes were labeled as divergent and viewed as a threat to the existing social order. In the stock market, those divergent souls are called value investors and they're mostly gone.
In a recent CNBC interview, hedge-fund mogul David Einhorn said:
The value investing industry are my former peers that were paid money to manage money for other people, that spent their time researching stocks and trying to identify undervalued companies to buy. Many of them operated in long-only institutions, like mutual funds... and they used to be paid lots of money to identify these stocks. Well, with the shift to indexing, where trillions of dollars has been redeemed out of those [value] strategies, those people have lost their jobs and they have lost their assets under management. So there's a lot fewer people right now looking to try to buy undervalued companies.
But Einhorn's tale ultimately has a happy ending for value investors:
So, for the few of us that are still doing it... It's a much better situation than it was when there was all of this competition before.
That's good news because, like I said, I'd never tell you not to buy stocks at all, or to sell all the ones you own. Investing doesn't work like that. When the overall market is getting risky, you don't sell everything and head for the hills. You do like I said and prepare, perhaps by holding plenty of cash and precious metals.
Einhorn's comment also shows investors a way forward that's likely to come with less risk and higher returns than the highly concentrated bets most folks are making today. Value investing can provide you with a huge competitive advantage compared to the overcrowded momentum trade.
mce-anchorFor example, Einhorn discussed a Belgian chemical company called Solvay (SLVYY) in his CNBC interview, which was yielding 10% when he first discovered it. Going public with his position Wednesday at the Sohn Investment Conference in New York pushed the relatively illiquid stock up as high as 20%. But even at recent prices, it's still yielding around 7%, a substantial payout, if the dividend is as secure as Einhorn suggests. We're not recommending the stock in these pages, but it could be worth a look...
Whatever you do right now, I'm convinced that avoiding trouble is far more important than seeking to maximize returns. Holding plenty of cash and embracing a value investing strategy are two ways to do that without running scared from a pricey market.
I'm not technically making a prediction...
