Investors need to remain cautious this year and take steps to protect the value of their capital. That means not chasing stocks that are getting too expensive for the wrong reasons.
So says Michael E. Lewitt, a fund manager and editor of the Credit Strategist newsletter who expects the S&P 500 to drop by year-end.
“Stocks are rising in the face of serious valuation and earnings headwinds,” he writes in his March 1 edition
. “The combination of collapsing energy earnings and a stronger dollar are moving year-over-year S&P 500 earnings lower.”
He points to estimates of company earnings that show weakness spreading beyond the energy industry, whose profits have plunged with the crash in oil prices since last summer. Wall Street strategists forecast that the S&P 500’s earnings will drop 1.4 percent in the first quarter, led by a 62 percent decline in energy industry results.
Investors have shrugged off those estimates as they push stocks to record levels. But equities are getting expensive, Lewitt says.
One of Warren Buffett’s favorite indicators, the ratio of the S&P 500 market capitalization to gross domestic product, is now at 1.27 times, or nearly twice the 0.65 median, Lewitt says. The Shiller/cyclically adjusted price-to-earnings ratio is at 27 times, compared with a historical mean of 16.6 times.
Looking ahead, Lewitt says the forward price-to-earnings ratio is 17.7 times, compared with a historical average of 14 times, but that measure is suspect because of changes in accounting conventions and the massive amount of stock buybacks in the past few years.
The S&P 500’s price-to-sales ratio is 1.7 times, between the 2.1 times of the 2000 dot-com bubble and the 1.5 times reading of the 2007 peak.
But comparing market valuations with past bubbles is hazardous, Lewitt warns.
“Arguing that markets are fairly valued today because they are not as overvalued as the most absurdly overvalued market in recent history — the 2000 Nasdaq — is not only wholly unpersuasive,” he says, “it is a ticket to the boneyard.”
The other difficulty today is that investors have few other ways to invest profitably with bond yields at record lows.
“The last time stocks were remotely as expensive as they are today – 2000 – bond yields were much higher and offered a genuine alternative to investors,” he says. “While stock prices may continue to rise from here, they are doing so from extremely elevated levels.”
To weather a possible decline in stocks, investors should allocate part of their assets to cash, says Kirk Spano, an investment adviser at Bluemond Asset Management.
He recommends putting 25 percent to 50 percent of an investment portfolio in cash or short-term Treasury funds, depending on risk tolerance and time to retirement, according to his column on MarketWatch
“There is a perception by people with big money that investing is becoming more risky,” he says. “If you are nearing retirement, that is something you should hear loud and clear.”
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