I Don't Know {Neither Does Anybody Else}

Here is a small list of things that I currently don't know or can't emphatically answer.

I don't know if the stock market is expensive.  Right now its valuation is rich when measured against many traditional methods.

I don't know if the stock market is cheap or fairly valued.  There is an argument to be made that stock valuations don't look so expensive if corporate earnings have stopped declining and if interest rates remain low.

I don't know the current state of the economy.  It is obviously not growing as fast as we've seen after other post World War II recessions, but we have been growing since 2009.  That has been the theory behind all of the "Things Are Getting Better" posts I've put up here over the years.  

In regards to the economy, my theory is that economic growth is better than we see because we don't have good ways to capture all that's going on in today 's economic landscape.  I of course don't know if I'm right about that.

I don't know whether oil should trade to $15 dollars a barrel or $60.

That's a lot of things that I don't have an answer to in a business where I get paid to manage people's money.  So let me now tell you what I do know.

Nobody else knows the answers to any of the questions I posed above because nobody knows what the future will bring.  The folks that emphatically tell you they know on television are mostly "Show Men".  They are there to provide entertainment.  Those that think they know for sure what's going to happen tomorrow or six months from now are either trying to deceive us or deceiving themselves.  

When it comes to the markets there is a debate on whether stocks are expensive or cheap.  There is always that debate.  It is as pointless to discuss as speculating on intelligent life on other planets.  Nobody knows the answer.  You can outright guess or use probability.  We prefer probability.  Here's the current facts.  

Stocks are expensive on current valuation measures.  However, they may not be quite as expensive if earnings start to accelerate in the coming quarters.  Also we are in uncharted waters regarding interest rates.  Currently even at these higher valuation levels, stocks may be more attractive than bonds.  The dividend yield on the S&P 500 is higher than the 10 year US government bond.  

We have pegged our current Cone of Probability for a range on the S&P 500 between 1,700 and 2,150 for this year.   We use this as a basis for our analysis and there's no law that says this range is valid for the rest of the year.  For all we know stocks could explode much higher or some event could trigger a sell off that takes us below our probability ranges.  But if we assume that stocks will trade somewhere around these levels then based on current S&P prices there's the potential for about 3% upside and over 20% downside.   That is not great risk/reward.  Contrast this with the market's trough back in February when stocks showed downside range potential of 8% and upside possibility of nearly 20%.

We are beginning the seasonal period of the year when stocks have traditionally had lower returns.  We've discussed this many times in the past and it is enough of a statistically proven concept for us to say there is a higher probability that stocks will struggle between now and sometime in the fall.   Of course, this could be the year that proves to be the exception.  It could be that stocks ignore past history this summer and explode higher.  That I think would cause a lot of pain and consternation amongst the professional investor class.  Even though this could occur,  an explosive move higher is likely a lower probability event based on past history.  As a side-bar it seems most major international and domestic crises have their origins in this same seasonal period.  Unexpected events have a way of cropping up and have many times spawned market declines during this period.

Presidential election cycles produce uncertainty and that's something investors hate.  It is a higher probability event that volatility will expand in the coming months.  

Markets are overbought in all of the time frames we measure.  This status can continue for some period of time, especially in more speculative environments, but it is a higher probability event that markets struggle when they are overbought like they are now.

Market volume and investor interest wains over the summer months.  This can impact market liquidity also leading to a higher probability of expanded volatility.

So what should investors do?  I can't answer that individually as I don't for sure know what stocks will do in the coming months.  I can give you the probabilities but I have no answers.  I also don't know specific risk reward profiles.  In general though this is what we do for our clients and this is what I'd suggest doing.

1.  Know what you own and why you own it.  Check to see if you're comfortable with your portfolio's asset allocation.

2.  Know your investment time horizon.  Think about portfolio and market allocations differently if you are one or two years away from a major event like paying for college or retirement than if you have a 10 or 15 year time horizon.

3.  Look yourself in the mirror and ask this question.  What's going to bother me the most.  What will keep me up at night?  A'm I comfortable watching the markets grind lower and perhaps seeing double -digit losses in my portfolio sometime this year.   Or will it bother me more to raise cash and see the market move higher.  Nobody can answer this but yourself.

4.  De-risk your portfolio.  Get it to a place where you're comfortable with your investments.  Our primary method for de-risking is to raise cash.  Cash may not pay much right now but sometimes earning next to nothing beats losing money.  While not at what I consider excessive levels, I currently have higher cash levels in most client accounts than perhaps what is the industry average.  My cash levels are such that I believe my clients will still participate in much of the market's advance should stocks continue moving higher.  The cash levels should also help cushion a market decline and give us the opportunity to find value should a market correction occur.  That's something I'm comfortable with as are I believe my clients.  It is often easier to make up opportunity than losses.  

*Long ETFs related to the S&P 500 in client and personal accounts.  Please note that positions can change at anytime without notice here on this blog.