How to Protect Your Investment Portfolio if Current Market Valuations Are Not Sustainable Brendan Greenwood CIM, QAFP, B.Comm | May 20, 2021
It’s Been an Exciting Twelve Months for New Investors:
A lot of money has been made very quickly in the stock market since its deep correction last March. Stuck at home, lockdown measures left few places for people to spend money. With extra cash and near zero percent interest rates, millions of new investors started purchasing stock in companies benefiting from the lockdown like Netflix and Peloton, as-well as bet on the recovery of companies affected by the pandemic like Carnival Cruise Line. Companies also in some cases bought back their own stock pushing stock prices even higher. Since the stock market bottom in March of last year both the Dow Jones Industrial Average and the S&P 500 gained over 75%. This was their best 12-month performance since February 1934, according to Dow Jones Market Data.
In the 12 months since the market bottom last year 96% of US stocks had a positive total return. People have started talking about all the easy money they were making in the stock market and this has encouraged others and themselves to invest even more money into the stock market. One new investor told me, “It’s all about buying stocks and making faster money”.
Stock Markets Don’t Move in Only One Direction:
To blindly be able to buy almost any stock and generate a positive return is a rare moment in history. Between 2000 and 2009 the total return for the S&P 500 was negative 9.1%, a sobering reminder that the stock market moves in two directions and you can have a period of extended negative returns as valuations adjust to a change in future expectations.
High Valuations Lower Future Expected Returns:
The CAPE Ratio is a relative measure of how expensive the stock market is. The ratio is calculated by dividing a company's stock price by the average of the company's earnings for the last ten years, adjusted for inflation. The CAPE ratio of the S&P 500 is currently at 37 which is more than two times its historical average. It is higher now than the period just before the 1929 crash, but lower than its peak of 44 when the dot com bubble burst.
The CAPE ratio along with current stock dividend yield provide a useful guide on potential future stock market returns. When the CAPE ratio is high and dividend yields are low the stock market tends to produce lower future returns. The dividend yield of the S&P 500 is at a historical low today.
The chart below displays what the US stock market returned at different initial P/E ranges, in the subsequent 10 years. In general, investors have earned higher total rates of return from the stock market when the initial P/E of the market portfolio was relatively low, and relatively low future rates of return when stocks were purchased at high P/E multiples.
What to Watch For:
Based on history, current market valuations are very high. Low interest rates and fiscal stimulus support higher valuations. You need to watch for signs of a persistent rise in inflation followed by a rise in interest rates. A meaningful rise in interest rates would likely push stock market valuations in the opposite direction.
Investment Portfolio Adjustments To Consider:
There has been a lot of talk about cyclical investments, especially commodities as being the place to invest during the economic recovery. This makes sense, but this a time you also want to build stability into your investment portfolio with investments that reduce overall portfolio volatility and generate consistent returns. Below is a list of possible options for you to consider.
Financial Firms: A steepening yield curve allows banks to earn a larger spread between the money they borrow and the money they lend out improving profit margins. As economic activity increases the amount of corporate borrowing should increase meaning banks and other institutions will be able to lend out more money increasing their revenues.
Real Estate Investment Trusts (REITS): Real estate investment trusts will likely earn more rental income as the economy recovers. REITs are known for providing stable cashflow to investors through out the entire economic cycle.
Floating Rate Bonds: The interest that these bonds payout adjust to reflect changes in interest rates providing a stable income stream. The floating interest rate payout means the value of the bond will not fall as interest rates rise mitigating interest rate risk usually seen with conventional bonds.
Short-term Corporate Bonds: These bonds provide higher yields then government bonds and mitigate interest rate risk by having shorter terms to maturity.
ETFs that combine Covered Call and Put strategies: These ETFs provide the opportunity for enhanced yield through their options writing and can add stability to a portfolio.
Having a well-rounded portfolio helps insulate you from severe stock market downturns, enhancing long-term annualized compound returns and providing more stable income for those that need it. The future is uncertain. Managing risk is always an important part of any sound portfolio strategy.
Brendan Greenwood is an Investment Advisor with Worldsource Securities focused on personal pension strategies and leveraging technology to provide progressive institutional style investment solutions for professionals, incorporated individuals, business owners, retirees and their families.
For other articles authored by Brendan Greenwood on issues impacting business owners and individual investors see https://www.greenwoodwealth.co/blog.
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