The S&P 500 recently made an all-time high in spite of sluggish U.S. and global economic growth. John Archer says this combination is a recipe for trouble so he is raising cash to reduce his exposure to the market.
John started his Marketocracy fund a little more than 2 years ago, but in 2015, just his second year, he beat the S&P 500, 7.60% to 1.38%, a feat that takes many people a lot longer to accomplish if they ever do. Before taking anyone’s investment advice, you should always check out their track record. Click here to see John’s.
Ken Kam: You have been raising cash in your TAB fund which is one reason you have lagged the market this year. What is your outlook for the market?
John Archer: As we know, elevated stock market valuations result in low return prospects and higher risk. Add sluggish U.S. economic growth and slowing and uncertain global economies to these circumstances and you have a recipe for trouble. It is a time to be cautious.
Kam: What metrics do you look at to determine whether stock market valuations are “elevated.”
Archer: The S&P 500 index recently reached an all-time high. The Buffett Indicator – the famed investor’s method of determining an over-priced or underpriced stock market is approximately 60% above its 65-year mean. The price of Morningstar’s coverage universe of stocks is trading above its aggregate median fair value. The current low interest rate environment is causing many individual fixed-income investors to take on more risk by piling into REITs, MLPs, and consumer staples stocks like KO, PEP, KMB and PG that sport dividend yields of 3%, 4% and more.
This demand trend toward dividend paying equity securities is fueling higher stock prices. As an example, stalwarts like KO, PEP, KMB, PG and others are trading at P/E ratios of 20 or more and are delivering low or negative revenue and profit growth.
Kam: What’s an investor to do?
Archer: There are four simple strategies I’m implementing in the TAB fund to prepare for what could be low to negative future returns.
First, be conservative and selective with respect to value. Although companies like KO, PEP and PG are generally considered high quality, their current prices are historically high. A good company is not a good investment if you pay a high price to own it. The stock market’s forward 12-month P/E ratio is currently 17.0 compared to the prior 5-year average of 14.6 and the prior 10-year average of 14.3. That’s currently almost a 20% premium to the 10-year average. I always try to purchase stocks with a “margin of safety” where the price paid is significantly lower than the estimate of the company’s intrinsic value.
Second, analyze the quality of stock holdings. Companies that generate high levels of free cash flow, have low debt levels, maintain positive net cash positions, enjoy high gross profit and operating profit margins and are known for exemplary management have a much better chance of outperformance in both rising or declining markets.
Third, establish a cash cushion. Most mutual funds and particularly index funds remain 100% invested, which in a richly priced market can be risky and result in greater volatility. A short-term cash position earns essentially nothing, but in a declining market it can partially mitigate risk and provide the flexibility to purchase high quality companies at lower prices. The TAB fund currently has a cash position of 26%.
Fourth, be patient and take a long-term view. It is common human behavior to over-react to perceived dangerous situations when money and retirement funds are at stake. It’s not unusual for the stock market to decline 10% or even 20% or more. An investor who maintains a long-term view will be better prepared to rationally invest when prices decline rather than selling in a panic when emotions are high.
Kam: Most investors in mutual funds and index funds believe that professional managers are watching these risk factors for them. Yet, as you say, most mutual funds and index funds remain 100% invested which many believe is too aggressive for this stage of the economic cycle.
Archer: I believe this is a perilous time for investors. There remains a high level of uncertainty and concern around the globe, slow economic growth, high levels of sovereign and individual debt, low to negative interest rates and high stock market valuations. It’s a time to be cautious and vigilant with respect to stock holdings. When the economic cycle returns to improved economic growth and more realistic asset values will be the time to make more timely investment decisions.
My Take: One the great advantages Marketocracy managers have over Wall Street is that they don’t have to be fully invested all the time.
Adjusting your exposure to the market by managing your cash is not market timing. It’s more like buying low and selling high. Let me explain.
You see, there is a predictable lifecycle for value investments. At first, a stock is cheap because no one sees any way the company can become more valuable. Next, a good value investor sees something about the company that Wall Street is missing and starts to buy the stock. At this point, the stock is still cheap but starts to move up as more value investors discover and invest in it.
If the stock moves up enough to attract the attention of momentum and quantitative investors the stock’s run will continue. Momentum and quantitative investors don’t really care why the stock is moving up, so their buying often pushes the stock above what the value investors consider to be “fair value” — sometimes way above fair value.
When a stock trades above fair value, good value investors sell and redeploy the proceeds into a different stock that has not yet come to fruition. However, in this case, John sees the whole market as overvalued so he is holding onto the cash until his market outlook warrants being fully invested.
Disclosure: I am the portfolio manager for a mutual fund advised by Marketocracy Capital Management, an SEC registered investment advisor. Before relying on the opinions expressed in this article, you should assume that Marketocracy, its affiliates, clients, and I have material financial interests in these stocks and may hold or trade them contrary to these opinions when, in our view, market conditions change.