A great storm recently blew through Toronto and took one of our trees with it. The young Kentucky coffee tree proved to be no match for the wind and the rain. After a fateful gust, it split down the middle, grabbed hold of my neighbour's power line and tumbled to the ground.
Another storm is brewing that could be more dangerous because it's headed toward the market. Early gusts have already knocked down Greece and Puerto Rico. Both had been previously weakened by mismanagement, economic hardship and high debt levels.
It also comes after a roaring bull market that pushed stocks sky high in the U.S. The S&P 500 hit a low of 667 in the spring of 2009, and it hasn't looked back since then. It was spotted floating above 2,100 two weeks ago, before it sagged a bit last week.
The problem is, the market's big run wasn't accompanied by a similar move in its fundamentals.
For instance, Nobel laureate Robert Shiller's cyclically adjusted price-to-earnings ratio now hovers near 26 for the S&P 500. That's well in excess of its average level of 16.6 based on data from 1881 to the end of last month. The ratio was higher only near the peak in 1929, during the Internet bubble of the late 1990s and for a brief spell before the 2008 collapse.
Similarly, the U.S. market's Q ratio (market capitalization divided by replacement cost) is elevated. Its market-capitalization-to-GDP ratio, a measure Warren Buffett likes to keep an eye on, is approaching all-time highs.
To make matters worse, we're now in the seasonally weak period that inspired the old adage to "sell in May and go away." Ben Jacobsen, of the University of Edinburgh Business School, and Sven Bouman, of Saemor Capital, studied the phenomenon and determined that stocks performed poorly from May through October in 36 of the 37 markets they investigated. Seasonality has also been a feature of the British market since 1694. As a result, investors should be particularly cautious in the summer and early fall.
In summary, the market trades at a high price compared with its fundamentals, we're currently in an off-season for stocks and governments are defaulting on their debts. It's not a bullish combination.
While I'm not predicting the market's imminent demise, I do want to ring the alarm bell when it comes to risk.
With the market at high levels, investors should make sure their portfolio's current asset mix properly reflects the amount of risk they can actually handle. After a long bull run, it seems like high time to indulge in a little rebalancing.
Complicating matters, it's devilishly hard to accurately determine just how risk tolerant you are. After all, it's easy to think you'll be able to handle the ups and downs of the market when times are good and risk seems to have taken a vacation. It's an entirely different matter when the vacation ends and the markets tumble.
That's why it's wise for investors to assume that – when push comes to shove – they'll be less risk tolerant than they think they are. It's something new investors – who haven't been tested by the big downturns of 2000 and 2008 – should keep in mind.
Practically speaking, many advisers like to put investors into one of five categories based on their risk tolerance. If you consult with them in good times and determine the risk category you should be in, it might be smart to dial it back a notch to better reflect how you'll likely feel during a big downturn. You can always move it up again after you've experienced a crash without becoming panic stricken.
It's time to put storm windows on your portfolio and sensibly prepare for what might be to come. If you wait too long, your portfolio could be caught out in the wind and rain.