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Time for a Caution Light for Stocks

New highs in the stock market are setting investors up for potentially challenging times ahead.  A six-year bull market fueled by the Fed's zero interest rate policy has valuations stretched.  Under normal times, investors could look to bonds for income and as a safe harbor from high stock values, but today's opportunities are anything but normal.  Bonds are providing little to no income and, even worse, when interest rates rise (and we all know that they will eventually rise), bond prices decline.  Times like these can make portfolio decisions difficult.

According to Ned Davis Research, when stocks are overvalued by more than 20% (when measuring what investors will pay relative to earnings), stock prices are lower by -3.6% one year later.  NDR currently has the S&P 500 more than 30% overvalued.

Source: Ned Davis Research
Does this mean the market has topped?  Absolutely not.  Valuation measures are never good for timing. Stocks, like any other investment, can stay over (or under) valued for months or even years.
Valuation indicators are, however, great tools for measuring risk.  And valuations currently suggest that risks are high for stocks.  This is confirmed by the Schiller P/E Ratio, developed by Yale Professor Robert Schiller. This ratio confirms that stocks have reached levels of overvaluation:
With stocks high and interest rates low, what should investors do?  Consider the following:
  • If heavily weighted in stocks, consider reallocating to take some risk off the table.
  • Alternative strategies can be a great opportunity to reduce risk through additional diversification. Once available only to ultra high net worth investors and foundations, alternatives are now available through larger investment management firms. It's even possible to enhance returns through proper use of alternatives in a portfolio.
  • Tactical asset allocation strategies can also be very useful during corrections or bear markets.  Just be careful to make tactical adjustments based on good research, not on emotions or preconceived beliefs about financial markets.

stacey_newAlways remember, the investment business is a business of making mistakes.  The difference between the winners and the losers is that winners make small mistakes and losers make big ones.  While the current weight of evidence still leans mildly bullish for stocks, my traffic signal is now yellow, indicating caution.

Stacey Wall serves as Chief Executive Officer of Pinnacle Trust.  You can reach Stacey by emailing him at swall@pinntrust.com or by calling him at 601-957-0323.