Managing the Downside
Managing the downside. Today, I am writing about managing the downside since I am increasingly of the opinion that U.S. equity markets are overvalued. In my mind it’s starting to feel like the dot-com boom times. What causes me to make that statement? The Shiller PE Ratio also popularly known as the Cyclically Adjusted PE Ratio or ‘CAPE’ is above 30. This number has significance. In the modern stock market, which I define as 1970 – Present, the Ratio has only been over 30 during two time periods.
First some history on the Shiller PE Ratio. It was during the dot-com boom or some people say bubble that Professor Robert Shiller popularized the Ratio that he had developed along with John Campbell. In his book Irrational Exuberance, published in March 200, he examined economic bubbles and also argued that equities were overvalued at that moment. The book was prescient as the long bear market after the long run up in stocks started about then.
The first time the Shiller PE Ratio went over 30 was during the dot-com bubble. On a monthly basis the Ratio went over 30 in June 1997. The Ratio then went over 40 in January 1999. It peaked in December 1999 and January 2000 time frame. The Ratio bottomed out at about 21.3 in March 2003. Fast forward to 2020. The Shiller PE Ratio went over 30 in August 2020 and has been there since then. It is interesting to note that the Ratio went over 30 in 1929, before one of the most brutal bear markets. You can scroll down to the bottom this post to see the Shiller PE Ratio over time.
Shiller PE Ratio for Managing the Downside?
So, based on the above, it seems like the Shiller PE Ratio can be used to predict bear markets and for managing the downside. If you believe that the Shiller PE Ratio is predictive based on past history then it would be time to lighten up on equities and possible increase allocation to other asset classes. This would be managing the downside. But is this a reasonable expectation and response by investors? Is it really that simple? Not really.
Managing the Downside is Difficult Based on Historical Data
Some investors or academics do not view the Shiller PE Ratio as predictive. For one, the average has been trending up over the years. The average over the past 100 years is roughly 17.7. The average over the past 50 years is about 20.5. The average since 1989 has been about 25.9. So, if the Shiller PE Ratio’s average is in fact moving upward then using historical data may not be sensible for managing the downside on equities.
That said, there seems to be a trend between the Shiller PE Ratio and annualized inflation-adjusted or real returns in future years. The graph below is from a study by Star Capital that shows an inverse relationship between the Shiller PE Ratio and real returns in the subsequent 10 – 15-year time periods. Lower values for the Ratio indicate higher returns and vice versa. This study uses all data for the S&P 500 going back to 1881. Granted, there is a lot of variability in the data, but the trend is unmistakable. However, there are some discrepancies that make using the Ratio problematic in my opinion. Both Sweden and Denmark have relatively high returns even at a CAPE Ratio of 30 or more. The R2 value is low though meaning that the relationship is not truly predictive. Next, a study by Vanguard concluded that only 43% of returns were predicted by the CAPE Ratio from 1926 – 2011.
However, the relationship between the Shiller PE Ratio and real returns seems to have gotten stronger since 1995 as shown by another study by Michael Finke. The chart below shows the relationship between the two variables from 1995 – 2020. It’s almost an inverse straight line. This study concluded that 90% of variability in returns can be predicted by the Shiller PE Ratio. Further, returns were within 2.74% of the returns predicted by the CAPE Ratio 95% of the time.
Practical Aspects of Managing the Downside
If you believe the results of Finke’s study, then it may truly be prudent to think about the managing the downside in the present market. But the chart does show that actual returns will be positive based on a Shiller PE Ratio of 30. It is when the Shiller PE Ratio goes over 40 that returns are expected to be negative. Looking at the dot-com bubble, there was an 18-month lag between the Ratio going over 30 and the start of the bear market. Although the Ratio can be an indicator of overvaluation, stocks can still go up.
However, it is never too early to think about risk and asset allocation. We are at end of the calendar year and many individual investors start thinking about rebalancing. The S&P 500 was up about 28.9% in 2019 and is up over 14% year-to-date. The NASDAQ Composite was up about 35.2% in 2019 and 37.9% year-to-date. On the other hand, the Dow Jones 30 was up only about 22.3% in 2019 and 5.9% year-to-date despite recent changes to its composition. Still, many stocks are setting 52-week highs and all-time highs. This has been driven by a changing market resulting from COVID-19. The Fear & Greed Index is measuring Extreme Greed. An investor who is very heavy in equities would likely move to lighten their allocation to stocks when managing the downside.
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Dividend Increases and Reinstatements
American Eagle Outfitters (AEO) is paying the previously suspended dividend of $0.1375 per share on December 30, 2020.
Bassett Furniture (BSET) declared a special dividend of $0.25 per share.
TTEC Holdings (TTEC) declared a special dividend of $2.14 per share.
Nucor (NUE) hiked the dividend 0.6% to $0.405 per share from $0.4025 per share. This is the 48th yearly increase in a row. Nucor started paying a dividend in 1973. Nucor is a Dividend Aristocrat and Dividend Champion.
Coronavirus Dividend Cuts and Suspensions List
I updated my coronavirus dividend cuts and suspensions list this past Wednesday. The number of companies on the list has risen to 481. We are well over 10% of companies that pay dividends having cut or suspended them since the start of the COVID-19 pandemic. The number of companies on the list continues to rise each week.
No new companies were added to the list in the past week.
I included five companies that I had previously missed. The five companies that I previously missed were VOC Energy Trust (VOC), Eagle Point Credit Company (ECC), Ellington Financial (EFC), William H. Sadlier (SADL), and Elmer Bancorp (ELMA).
Dow Jones Industrial Averages (DJIA): 30,218 (+1.03%)
NASDAQ: 12,464 (+2.11%)
S&P 500: 3,699 (+1.67%)
The S&P 500 is trading at a price-to-earnings ratio of 37.4X and the Schiller P/E Ratio is at about 33.8X. These two metrics are up again this past week. Note that the long-term means of these two ratios are 15.8X and 16.7X, respectively. I continue to believe that the market is overvalued at this point. I personally view anything over 30X as overvalued.
S&P 500 PE Ratio
Shiller PE Ratio
Stock Market Volatility – CBOE VIX
The CBOE VIX measuring volatility was essentially unchanged with last week at 20.79 at end of this past week. This is the lowest level since the pandemic started. The long-term average is approximately 19 to 20. So, at this point we are just slightly above the long-term average and trending down.
Fear & Greed Index
I also track the Fear & Greed Index. The index is in Extreme Greed for the second week in a row.
There are seven indicators in the index. They are Put and Call Options, Junk Bond Demand, Market Momentum, Market Volatility, Stock Price Strength, Stock Price Breadth, and Safe Haven Demand.
Stock Price Strength is signaling Extreme Greed. The number of stocks hitting 52-week highs exceed the number at 52-week lows is at the upper end of its typical range. Stock Price Breadth is indicating Extreme Greed. Volume of advancing stocks relative to declining stocks is at the upper end of its range over the past two years. Market Momentum is signaling Extreme Greed. The S&P 500 is 10.18% above its trailing 125-day average. This above the average over the past two years. Put and Call Options are signaling Extreme Greed. Put option volume has lagged call option volume by 65.69% This is amongst the lowest level of put buying in the trailing two years. Safe Haven Demand is indicating Extreme Greed. Stocks are outperforming bonds by 6.86% over the last 20 trading days. This is near the higher end of the range in the past two years.
Junk Bond Demand is indicating Greed. Investors are accepting 2.13% yield over investment grade corporate bonds. This is about average over the past two years.
Market Volatility is set at Neutral. The CBOE VIX reading of 20.79 is a neutral reading.
The number of weekly new unemployment claims were up with last week at 712,000. This is down 75,000 from last week’s revised numbers. We are now below 800,000 claims consistently but have headed up over the past two weeks. But for some perspective, one-year ago weekly unemployment claims were only about 206,000. Currently we are 3X – 4X the normal level. The seasonally adjusted insured unemployment rate was 3.8%.
The ten states with the highest unemployment rates were Virgin Islands (7.9), California (7.3), Hawaii (7.1), Nevada (6.7), Alaska (6.4), Massachusetts (6.0), Georgia (5.7), Illinois (5.6), District of Columbia (5.5), and Puerto Rico (5.5).
The U.S. Department of Labor reported the unemployment rate fell to 6.7% in November, showing an improvement over October’s 6.9% rate. The economy added 245,000 jobs, down from 610,000 in October. The figure represents the fewest jobs number added in 7 months. Transportation and warehousing which added 145,000 jobs. In addition, professional and business services, health care, and construction and manufacturing all added jobs. Leisure and hospitality added 31,000 jobs. Retail jobs fell by 35,000, and foodservice establishments lost 17,000.
The EIA’s Weekly Petroleum Status Report showed that inventories U.S. commercial crude oil inventories decreased by 0.7 million barrels for the week as of November 27, 2020. At 488.0 million barrels, U.S. crude oil inventories are about 7% above the five-year average. Refineries operated at 78.2% of their operable capacity. Gasoline and distillate fuel production dropped by a combined 13.2 million barrels per day. Total products supplied over the last four-week period averaged 19.3 million barrels a day, a decrease of 9.0% from the same period last year.
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Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor, analyst, and writer on dividend growth stocks and financial independence. His writings can be found on Seeking Alpha, InvestorPlace, Business Insider, Nasdaq, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, and leading financial sites. In addition, he is part of the Portfolio Insight and Sure Dividend teams. He was recently in the top 1.0% and 100 (73 out of over 13,450) financial bloggers, as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.