It’s Time to Take Your Money off the Table

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Parties never last forever. No matter how much fun everyone is having. And the party on Wall Street is looking overextended.

People who arrived early have had a blast. They’ve been drinking the punch (spiked by the Federal Reserve, as usual) and dancing on the tabletops all night. And they think this rave ain’t ever gonna stop…

Alas, the host is drunk and nearly passed out. And the Fed is about to replace the spiked punch with coffee.

So, time to pack up and head for the exits.

What I’m saying is that it’s time to take some of your U.S. stock market positions off the table and preserve the cash so that you can go back in and grab bargains after stocks go through a necessary correction.

And a correction is baked into our future at this point. U.S. stocks are simply too expensive relative to norms and relative to the risks to corporate earnings today.

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I watch a stock market indicator known as the Shiller price-to-earnings ratio. Noble economist Robert Shiller designed it to better calculate true value in the stock market. It relates a market’s overall price to the average, inflation-adjusted earnings over a 10-year period, thereby smoothing those volatile one-off moments that distort perceptions of value.

In short, it offers a truer picture of value.

That picture today: U.S. stock markets are trading at a Shiller P/E of 26. Only two times in the last century or so have U.S. stocks traded at such airy levels — just before the Great Depression and again during the bubble-fueled Greenspan years. In both cases … well, you know the result.

I’m not saying we’re headed for a crash that sends the U.S. stock market reeling. But we are destined for a decline and a lackluster stock market for years as corporate profits catch up to valuations.

And that’s where the real struggle is evident.

The U.S. Stock Market Is Set to Fall

You see, overall corporate profits were at nosebleed levels in recent years, nudging right up against 10%. They have since begun to decline and are now at 8% — which is still high relative to post-war norms in the 4% to 6% range.

And, of course, earnings drive stock prices — they are, after all, the “E” in the P/E ratio. As the E comes down, the ratio gets larger and larger and larger if prices — the “P” — do not adjust.

Our problem is that the E has farther to fall.

Corporate profits are impacted by interest rates … and interest rates are heading higher as the Federal Reserve begins to delicately extricate itself from the rock and the hard place it navigated into over the last couple of decades. That’s not likely to happen until 2016 (I’m calling it now: A September rate hike is off the table). But remember that the U.S. stock market always looks ahead, and that prices move based on expectations.

Once a rate hike seems real, stock prices will adjust lower … and right now a hike doesn’t seem real because the Fed has been very wishy-washy on when it will finally act.

What we are looking at, then, is a reversion to the mean.

U.S. stock prices will weaken as the Shiller P/E falls back toward a more normalized level in the 15 to 16 range. (And, no, there’s not a chance that earnings ramp up so fast that they catch up to the price level … that would imply an economy growing dramatically faster than America can generate, or it would imply corporate profit margins explode even higher than their already extended levels. Neither is probable or likely.)

Take Some Money off the Table

We’ve had a helluva run on Wall Street since the end of the financial crisis. The S&P 500 is up more than 205% since March 2009 — nearly 21% a year on average. That’s insane…

And short-lived, without a doubt.

We’ve all heard that U.S. stocks, on average, rise about 10% a year over time (and it’s actually been 9% a year if you go back to 1982, when the Fed began its epic three-decade push to drive U.S. interest rates lower).

If we start with the S&P’s trough in 2009 — in the 675 range — and go out 10 years with an average 10% annualized return, we get to an S&P value in 2019 of roughly 1,700.

We are today sitting at nearly 2,100.

For the S&P to return to a normalized trend line, we’re looking at negative annualized returns of between 4% and 5% a year through the end of the decade.

That doesn’t necessarily mean down 5% a year. We could see a big sell-off that brings the U.S. stock market well under 1,700, and then a slow, gradual, dull decline back to fair value. Or we could just see a gradual drift lower over years as we wait for corporate earnings to catch up to prices.

The point is simply that America is a markedly overvalued stock market today. That must change. And the best prescription with this known change in the offing is to take some winnings off the table and wait for a lower entry point … or to even put some of that cash to work in Europe, where stock valuations are not as stretched, where many economies are faring better than the U.S., and where profit margins are actually on the rise.

Until next time, stay Sovereign…
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Jeff D. Opdyke
Editor, Profit Seeker