"BULL MARKETS GO UP LIKE ESCALATORS; BEAR MARKETS GO DOWN LIKE ELEVATORS!"

Another man's vivid image of markets which resonates with me.  Bull markets die hard!  It takes time for one to form a top.  Bear markets, on the other hand, generally end with what I have called a waterfall decline, a "puking" phase, or a selling climax. (See my posts during 2008 and 2009.) This asymmetry of stock market phases has dictated my asymmetric money management approach.  During the bull phase, I rebalance my equity exposure back to my core 30% position as the Standard and Poor's 500 Index (the "Index") becomes more and more overvalued according to Shiller's CAPE ratio*.  On the other hand, during the bear phase, I rely only on technicals --trading volume, market breadth, and price -- to confirm a market bottom.  At that point, time is of the essence; and my adjusted CAPE ratio determines how much I add to my equity risk exposure.

At  2578 today,  the Index became close to 89% overvalued according to Shiller.  In previous posts, I have mentioned that 90% would be a call to action.  To me, the tax decreases likely to be passed have already been discounted by the market. And any meaningful tax code overhaul will be a long slog.   Today I rebalanced my equity exposure back to my core 30% of financial assets.  Next stop: Shiller's 100% overvaluation.


The "Search For Yield" Trap

As you know, I believe in mean reversion in both stock P/Es  and bond yields.  I also feel that Shiller's CAPE ratio is helpful in determining how far stock P/Es  have strayed from their mean.  As stocks and bonds both become more overvalued, I reduce risk in both of these asset classes. In  certain circumstances, like now,  cash becomes a legitimate asset class.

A good example of this is how I have managed my two daughters' financial assets. Their core equity exposure over the last several decades has been an aggressive 100% of their financial assets.  Originally, the money was invested equally in four no-load equity mutual funds--a Standard and Poor's 500 Index fund, and three T. Rowe Price funds with a higher risk: New Horizons, Small Cap Value, and New Asia.  So 75% of the accounts were then in funds with a higher risk  than in  the Index.

As the Index became more overvalued, I have been reducing the equity risk exposure in these accounts, with the proceeds invested in cash equivalents because bonds are overvalued as well.  Now the equity exposure is 55% of financial assets, with 45% in cash.  Furthermore, the composition of the equity exposure has changed.  Now 50% of the accounts are in the Index fund, with only 50% in the higher risk funds.

As stocks and bonds become more overvalued,  many money managers are compelled to do the  opposite: they are increasing risk in their clients' accounts. This is due to managers' abhorrence of
cash.  In fixed income, their search for higher yield takes them from U.S. government bonds to investment-grade U.S. corporates to high-yield U.S. corporates to emerging market corporates.  In equities, as the Index becomes more overvalued, they go farther out on the risk spectrum by investing in, for example, emerging market funds.

This makes no sense to me; for their clients, this will end badly!



* An arcane point--in calculating his CAPE ratio, Shiller uses the average earnings (adjusted for inflation) over the last ten years.  During the Great Recession which began in late 2007,  Index annual operating earnings fell from 91 to 40 in eight quarters. During the next eight quarters these depressed earnings (adjusted for inflation) will be dropped and the expected strong current earnings will replace them.  Absent a recession during this period,  the result will be  an additional significant temporary jump in Shiller's earnings  in each of the next two years -- thus putting downward pressure on the CAPE ratio.  However, during the next recession,  this positive impact on Shiller's earnings will ultimately be reversed. Nevertheless, short term, this will be grist for the bulls' mill.