President Trump likes to talk about fake news. When he says it, I draw an analogy, and that is to fake money.
Central banks have been printing money and artificially propping up asset prices since the credit crisis almost a decade ago. That created fake demand for global assets such as bonds, stocks and real estate. In January, however, fake-money demand for assets failed to outweigh natural selling pressure. This is a new paradigm, and investors need to know what to do.
I have documented the significant changes to liquidity that have taken place, and the correlating natural demand for these same asset classes is defined by The Investment Rate. The conclusion is that there’s a balance now that has not existed in years, and that opens the door to more normal market conditions.
Normal market conditions have volatility. Normal market conditions have risk. In normal market conditions, investors care about valuation. And in normal market conditions the price-to-earnings (P/E) multiple on the stock market matters too.
Currently, the P/E multiple on the S&P 500 Index SPX, -0.08% is 24.8. Since 1900 it’s been an average of 14.5, so it’s now 41.5% higher than normal. Multiples have been higher before, but only during recessions when earnings collapsed, and that’s not the case today.
Although the bull market may officially be over, we had been in a raging bull market until January ended, and the PE multiple on the market today makes it the most expensive bull market in history.
Also, if the bull market is indeed over, which I think it is, the normal market conditions that follow will eventually lead to a fair multiple on the market. That presents a downside risk of 41% before normal multiples are realized. A decline like this would not require anything more than a change to risk perceptions, and the process of change has officially begun.
What to do
What are investors supposed to do now? In an article I wrote last week I offered a way to trade the market using our Strategic Plan, but there’s a more conservative method that’s easier for investors to embrace. The underlying notion is that you need to take steps to protect your assets.
The process I use for our CORE Portfolio Strategy is simple and can be used to achieve this goal without selling assets that may have large capital-gains tax consequences. The process used for taxable accounts is listed below.
Step 1: Determine which market your portfolio tracks. Your broker may have software that allows you to compare your portfolio to, for example, the S&P 500, Dow DJIA, -0.14% , Nasdaq 100 NDX, +0.21% or Russell 2000 RUT, -0.41%
Step 2: Identify an inverse ETF for the market that your portfolio most correlates to. For the S&P 500, it could be ProShares UltraShort S&P500 SDS, +0.15% for the Dow, ProShares UltraShort Dow30 DXD, +0.24% for the Nasdaq 100, ProShares UltraShort QQQ QID, -0.32% and for the Russell 2000, ProShares UltraShort Russell2000 TWM, +0.05%
Step 3: Divide the amount of your invested assets in half. For example, if you have $100,000 invested and the assets correlate best to the S&P 500, then half the value would be $50,000.
Step 4: When the markets are poised to decline, buy $50,000 worth of SDS. That can neutralize your portfolio from market declines.
Step 5: When the declines look exhausted, sell SDS, and use the proceeds to buy shares of direct-market ETFs like SPY, DIA, QQQ or IWM. These direct-market ETFs are much easier to completely neutralize; that is one reason I prefer to use them in our CORE Portfolio Strategy.
The process above can be repeated regularly. If done correctly, it can also have a compounding influence. Not only can you protect assets in this new paradigm, but if you invest the proceeds and own additional shares at lower prices, it will create a compounding influence on your portfolio too.
Thomas H. Kee Jr. is a former Morgan Stanley broker and founder of Stock Traders Daily.