Well, the stock market has certainly gone crazy, with the Fed pumping in money and another round of stimulus being offered (with more on the way?). In addition, the operations by day traders has increased dramatically, further fueling a rise in the market (can you say Tesla?). For many folks, the double-digit increase in the market at the end of the year was a welcome bonus. Still…….
I wrote earlier in the month about how I was moving out of bond funds. I provided my reasons, and the numbers behind my decision. At the time, I was thinking that the bonds just couldn’t keep up with the market, and were holding me back.
As part of my new year analysis, I look at some basic finance info to try and get a “feel” for the direction of the market, based on the writings of Ben Stein in his book “Yes you can Time the Market.” Its pretty much the trends on stock price, P/E ratio, and bond yields. I used it to determine how well I would have done if I followed it since I graduated (Roughly 8% – 11% better than straight dollar cost averaging over last 35 years), at the end of 2019 (where it predicted a drop) and in mid-March 2020 (where it predicted you should jump back in). The overall lesson is that, if you have a long-term outlook, you can do a little better than just following the market.
Well, the concept is there are four (4) areas where you can follow the trend and determine if you should be purchasing stocks, or purchasing bonds.
- Price of S&P500 vs. 15-year average: Jan 1, 2021 = 3,756.07 vs.15-year average of 2,160.4. Signal says stocks are overpriced, do not buy more
- S&P500 P/E ratio vs. 15-year average: Jan 1, 2021 = 37.74 vs. 15-year average of 24.7. Signal says stocks are overpriced, do not buy more
- S&P 500 Dividend yield vs. 15-year average: Jan 1, 2021 = 1.55% vs. 15-year average of 2.04%. Signal says stocks are overpriced, do not buy more
- Earnings vs. AAA corporate Bonds. Jan 1, 2021 = 2.65% (1 / PE ratio of 37.74) vs. AAA bond yield of 2.28% (very low yield). Signal says bonds are provided lower yield (though not by much) so bonds are overpriced for their yield
So 3 of the 4 signals say stocks are overpriced, and the 4th one is a close as it has been in a decade. All signs seem to speak to current stocks being overpriced.
Note that the concept does not suggest you should sell all your stocks, or sell all your bonds. What it is saying is that in the current environment, the stocks (or bonds) are too high priced, and you should focus your purchases on another asset class. Relook at it later on, and potentially change your purchases with the new data (I look at it once/year).
So why the subject line? Well, its often said that you should have an investment allocation that it aggressive, but still lets you sleep at night. After finding out that the P/E ratio was 37+ yesterday, I had a difficult time sleeping last night. The other times when this ratio topped 35+ was right before the dot.Com bust (2001) and the great recession (2008).
I know I just changed I just changed my allocation to get out of bonds, but I’ve decided to go back with them (20% of my allocation). I think the market is just a little too expensive right now, with all the money being pumped into it. I may end up with lower returns than some other folks – but it will help me sleep better at night.
How are you guys doing with the run up?
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Mr. 39 Months