What are the risks in this overvalued stock market

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In our latest economic report, we discussed overstretched valuations for U.S. stocks as an opportunity to take profits and purchase precious metals and collectible coins at reduced prices.

 

Were not the only firm noticing the risk of elevated valuations as stock market indexes continue to push higher. As one example, Cumberland Advisors, a registered adviser with $2.4 billion in assets under management, recently took profits from their equity positions and move the proceeds into cash. As firm chairman David Kotok wrote in a December 12 commentary: At best, stocks are fully priced. There is little margin for a stumble now.

Still, stocks continue to charge ahead into rarified air. Investor optimism is surging as the major equity indexes cross into record territory. Fund managers are moving sideline cash into stocks and raising equity allocations to two-year highs. This market rally is beginning to look like its running on emotional vapors.

Of course, stock prices alone cant tell you if the market is overvalued. Earnings matter in the equation too. The S&P 500s current price-to-earnings ratio of around 25 reflects the recent run-up in stock prices, although corporate earnings rebounded as well in the 3rd Quarter.

Yale economics professor Robert Shiller developed a different approach for calculating the P/E ratio, using a long-term moving average for earnings adjusted for inflation (rather than the 12-month trailing or forward earnings used in the basic P/E ratio.) Shillers cyclically adjusted price-to-earnings ratio, or CAPE ratio, is not a perfect tool and shouldn’t be used to predict future market returns. It can, however, be helpful for setting expectations when considered with other barometers of market valuation. (Here’s more about CAPE from the source and a discussion the ratios shortcomings.)

As of this writing, the CAPE for the S&P 500 Index sits around 28. That’s as high as its been since the bear market of 2000-2002. For a long-term perspective, the CAPE ratio average, going back to 1926, is 17.

Ben Carlson of Ritholtz Wealth Management recently analyzed CAPE at different ranges, looking at the annualized S&P 500 returns over the ensuing three-, five- and ten-year periods. When CAPE has been above 25, the S&P 500 has under-performed in the intermediate- and long-term. The best returns, on the other hand, have come when CAPE is at least below 15.

 

But average annualized returns don’t tell the whole story. Just because one gauge shows an overvalued market now doesn’t mean its due for a correction soon. Consider the range of returns when CAPE has been over 25: annualized returns over the next three years have been as high as 29%. But they’ve also been down as much as -42%.

 

Here’s another way to look at it; the lowest highs and the lowest lows for the S&P 500 Index have occurred when stocks have been at the highest valuation level (using CAPE as the barometer).

Here’s the takeaway for investors on looking at these valuation gauges: The stock market bulls may continue to run, even with valuations at their current nosebleed levels. If that’s the case, strong equity performance will likely come at the expense of gold and precious metals values.

But as long as the P/E readings stay elevated, the risk of stock market downturn remains high. And that downturn, if and when it happens, has the potential to be significant.

Such a reversal in momentum will likely swing investor sentiment back toward gold and other precious metals and tangible assets. That’s why we believe investors who maintain their gold allocations or even better, can add to them in this recent spell of price declines are positioned well for the current high-risk investment climate.