The Three Disconnects That Threaten Your Portfolio

“The market can remain irrational longer than you can remain solvent.”

—John Maynard Keynes

It is my opinion that we are at or very close to a critical juncture in the equity markets. The disconnections I see are at some of their greatest extremes in history. This does not normally turn out well in the near to intermediate-term. Investors would be well-advised not to get caught up in the present day euphoria but maintain their investment discipline. Investors can be better served if they understand the three major disconnects in the equity markets and strongly consider going against the current tide.

Disconnect #1: Valuations

Measured by a variety of measures—Tobin’s Q, CAPE/Shiller 10PE, the “Buffet” indicator — the market’s current valuation is at its most extreme with the exception of the peak in 2000. However, if we broaden the market universe by using the Wilshire 5000 instead of the S&P 500, or if we use price to sales, the median stock has never been more expensive in recorded history. This is unlikely to end well. Some believe that the low yields of bonds justify the high valuations since “there is no alternative.” Maybe, but I doubt it, and history doesn’t seem to indicate this. Current valuations imply negative rates of return in US stocks over the next decade for buy and hold investors despite low interest rates. In fact, low bond yields actually mean that portfolios diversified into bonds will have total returns only marginally better over the next ten years than equity-only portfolios. Can the pendulum continue to swing in the current direction? Absolutely, but it is still a pendulum and will swing back at some point.

Disconnect #2: US Stocks vs. Foreign Stocks

US stocks have outperformed foreign stocks by a historically wide margin since 2011. US stocks similarly outperformed foreign stocks in the late 90s, but after the dot com crash, foreign stocks doubled the performance of US stocks between 2003 and 2007. The current pendulum swing to US stocks may still have room to run, but the return swing will likely come soon. Historically, foreign stocks crash harder than US stocks, so perhaps like in 2003, the foreign outperformance will occur after the next major bear market bottoms.

Disconnect #3: Growth Stocks vs. Value Stocks

The current outperformance of growth style stocks over value style stocks is at its greatest extreme in history, even more than the discrepancy in the late 90s. This is despite the fact that value stocks outperform growth stocks over time historically. To think that growth can continue to outperform value indefinitely is to ignore history.

How to Blow Up Your Portfolio

In my opinion, if an investor wanted to create a portfolio that felt good, but was actually very dangerous, they would concentrate their portfolio in US growth stocks, especially the technology highflyers. In 2000 when the NASDAQ hit 5000, the popular convention was that the next stop was 10,000. It did recently get there, but not before losing 83% from its peak and taking 15 years just to get to break even. Be careful out there.

The Opportunity

So, based on all of this, why wouldn’t an investor just go to cash? Well, that may not be a bad idea, but keep in mind being too early can be the same as being wrong. The markets “feel” as if they are at a peak. But they “felt” that way in 1997, and the market climbed for three more years. Maybe the peak is within six months, and maybe it is still a way out.

So what is the alternative? Leaving aside our WealthProtect System, which is designed to reduce the risk of falling equity markets, an investor may want to consider shifting assets to reflect where the pendulum will go. This might mean lightening up significantly on stocks. This may also mean having a greater proportion of that stock allocation in foreign stocks. And it may mean allocating more of the stock allocation to value style stocks. It is possible that this is a good time for foreign value stocks. Emerging foreign value stocks meet all three criteria—they are relatively undervalued, they have underperformed US stocks for quite a while, and they have underperformed the growth style as well. This is not a recommendation—just a thought. By the way, as long as US growth stocks outperform, this will be a very uncomfortable portfolio. Being uncomfortable beats being clawed by a grizzly bear every time.

Call your wealth manager if you would like to review your individual portfolio.