Thane Stenner is portfolio manager and director of wealth management of StennerZohny Investment Partners+ within Richardson GMP. He is a founding member and chairman emeritus of TIGER 21 Canada and author of True Wealth.
These days, there are a lot of people trying to read the tea leaves, trying to understand how far the current rally will last, and what might happen when it ends.
In these "interesting times," the most important thing for investors is to determine what's worth focusing on and what's worth tuning out.
The challenge (as always) is separating important information from important financial information. Income and revenue, profit and loss – changes in these have a direct and largely predictable impact on asset prices. Sure, politics can have an impact too, but it's sometimes difficult to predict what effect a given policy will have on a given business (or even if such policies will come to pass). Perhaps most importantly, our beliefs and biases can lead us to interpret these signals emotionally.
I've written before about margin debt and one of the data points I keep an eye on when trying to get a big-picture idea of whether investors feel optimistic about the market.
Another one worth watching is the market-price-to-revenue ratio, which tracks the per-share stock price of index-component companies against their annual reported revenue.
Recently, this ratio was singled out by John Hussman, stock-market analyst and well-respected market commentator famous for correctly identifying the dot-com bubble, as well as the conditions that set off the housing bubble and subsequent financial crisis, back in 2007-08 (although he admits he got the 2009-present bull phase wrong).
The accompanying chart illustrates the price-to-revenue ratio of the broad-based S&P 500 stock-market index since 1986.
A few of points to make about the chart:
We're well outside of history
Over the very long term, the S&P 500's median price-to-revenue ratio has been close to 1.0. Since 1986, it's been higher than that – perhaps 1.3. That compared to 2.45 currently, which is the highest in history.
Here's a slightly different perspective: Look at the chart and you can see that, in more recent years, the ratio has bounced around a range – say, 1.3 to 1.7. To get to that level, current S&P 500 share prices would have to drop by somewhere between 40 per cent and 50 per cent.
Nowhere to hide
The S&P 500 is a broad-based index, capturing 500 of the largest U.S.-based stocks, across every market sector, and that indicates another potential danger for investors.
Back in 2000, for example, the overvaluation within the tech sector was extreme. It was easy to see and relatively easy to mitigate – all you had to do is use common sense and underweight tech stocks in your portfolio.
This time, it seems like most sectors/asset classes are overvalued. Simply put, there aren't a lot of places to hide.
It's time to play defence
Given the above comments, there's a compelling case to be made for shifting into full defensive mode. I encourage all investors to do what high-net-worth (HNW) investors have done for several months: Take profits on longstanding gains (or hedge them), trim or exit speculative "mad money" positions, be certain before committing new money to ideas and, of course, raise cash.
Depending on your situation, it may make sense to diversify outside the United States. While many HNW investors believe keeping money close to home is best, I am starting to see contrarians hunt for opportunities in deeply out-of-favour assets (Europe, Mexico, Japan). Such moves are not for the faint of heart, but in the spirit of being greedy when others are fearful, they could turn out to be very rewarding.
Most importantly, it makes sense to explore alternative assets non-correlated to the public equity market. I'm talking about long/short and market-neutral hedge funds, private equity, and, in some cases, very specialized real estate plays. It is always best to consult with a wealth professional for advice to see whether this strategy is right for you and your current situation.
Long story short: More and more signals are pointing to an overheating in the stock market. Instead of trying to score again, it's time to take your offence off the field and protect your lead.