With the bull market now 9 years old, the second longest in history, and interest rates rising, the media is filled with predictions of large stock market declines.
“Morgan Stanley: The biggest sell-off since February is coming and it’s going to hit the average investor hard.” CNBC, July 31, 2018
“Rising rates likely to shake stocks to core, veteran investor Peter Boockvar warns.” CNBC, July 25, 2018
Instead of getting scared by the headlines, let’s look at the research.
First, I must say that trying to pick every market up and down is fool’s gold. There are too many cross-currents influencing the market day-to-day to make consistently correct predictions. This is why investors tend to get such poor investment returns – they trade too much based on short-term predictions.
Instead, focus on the big picture. Major market tops occur 1-2 times per decade and require extreme conditions. To make your money last, consider managing risk only at extremes, not at minor events.
Second, after decades of research, I believe there are two key warning signs of major market tops that lead to 20-50% declines.
That’s right, just two. Everything else is noise. Here are the two:
Sign #1. Stocks are Extremely Overvalued Relative to Interest Rates
It’s critical to realize that overvaluation by itself is not enough. Stocks can be overvalued for years and continue to rise (for example, in the 1990’s). But when stocks become extremely overvalued relative to interest rates, bonds offer higher potential returns and stocks fall sharply to effectively re-price the assets for the new market environment.
Current Evaluation: Stock valuations relative to interest rates have risen considerably, but are not at extreme levels. Extreme overvaluation is a modest concern.
Sign #2. A Recession is Looming
During recessions, corporate earnings fall, reducing the value of stocks. Therefore, stocks tend to fall in anticipation of a recession. Unfortunately, while it is impossible to predict the exact timing of a recession, numerous indicators evaluated in the aggregate can often (though not always) warn that a recession is brewing.
Current Evaluation: The bulk of the evidence currently points to a strong economy that has more room to run. A looming recession is a low concern.
OVERALL CONCLUSION: Risks of a major top are modest. STAY INVESTED.
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