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This One Big Red Flag Signals a Stock Correction

The stock market’s behavior lately reminds me of the catch phrase of the fictitious mascot of Mad magazine, the gap-toothed Alfred E. Neuman: What, me worry?

A nuclear standoff, domestic political violence, excessive valuations, a chaotic White House — nothing seems to put a lasting damper on the bulls’ party. Not even the frightening spectacle of swastika-waving Nazis killing people in broad daylight on American streets seems to rattle investors.

The North Korean missile crisis did indeed spook traders last Thursday, sending stocks into a tailspin. However, conciliatory words from Pentagon brass have since soothed those anxieties and the markets enjoyed a subsequent relief rally on Monday.

Stock markets closed roughly flat on Tuesday, with the Dow Jones Industrial Average up 0.02% and the S&P 500 down 0.05%. Keeping markets steady was Commerce Department data released on Tuesday showing that U.S. retail sales recorded their biggest increase in seven months in July.

But this could be the calm before the storm. Below, I examine one big red flag that’s pointing to a stock market correction. Ignore this time-proven indicator at your peril. I also provide proactive measures for portfolio protection. The investment game may be getting riskier, but that doesn’t mean you have to sit on the bench.

Meanwhile, in the weeks ahead, investors should assume nothing. As internecine fighting tears apart the ruling Republican party in the nation’s capital, Wall Street’s coveted agenda of tax cuts and fiscal stimulus is suffering collateral damage. As we witnessed last Thursday, any crumb of bad news could send this overvalued market reeling.

Tea Party in DC’s Wonderland…

Exacerbating tensions in Congress is the hard-line stance of Mick Mulvaney, director of the Office of Management and Budget. As a Tea Party fiscal hawk, Mulvaney opposes raising the debt ceiling without draconian budget cuts, which sets up a major fight in Congress when lawmakers return in the fall from their August recess.

The odds of a federal default over the debt ceiling are greater than they’ve ever been, posing great danger to markets.

At the moment, robust corporate earnings are keeping the bull alive. With 91% of S&P 500 companies reporting actual second-quarter results, 73% of them have posted positive earnings per share surprises and 69% have posted positive revenue surprises. For the second quarter, the blended year-over-year earnings growth rate for the S&P 500 is 10.2%.

Nonetheless, operating results still don’t justify these sky-high valuations. Underpinning the upswing in equities has been a syndrome known as “TINA” (There Is No Alternative). That could all change very soon.

Don’t get me wrong: I have no patience with the carnival barkers in our business who predict calamity day in and day out. I prefer to deal in facts, as exemplified by the cyclically adjusted price-to-earnings ratio (CAPE).

The widely respected (and uncannily prescient) Professor Robert Shiller of Yale University invented the CAPE ratio (also known as the Shiller P/E) to provide a deeper context for market valuation.

The CAPE ratio is defined as price divided by the average of 10 years of earnings (moving average), adjusted for inflation. The ratio now exceeds 30.1, which is 81% higher than the historical mean of 16.8.

According to this long-term chart of the CAPE ratio, stocks in the S&P 500 are partying like it’s 1929:

CAPE Fear: Shiller’s P/E Flashes Red

Source: Yale Department of Economics

Shiller won the Nobel Prize for Economics in 2013, so he’s worth heeding. The Shiller P/E is illuminating whereas the traditional P/E is misleading. The key advantage of the Shiller P/E is that it eliminates the fluctuations in the traditional P/E generated by variations in profit margins during business cycles. During economic expansions, companies rack up high margins and earnings; the traditional P/E ratio in turn becomes artificially low. The converse happens during recessions.

The Shiller P/E isn’t the only red flag. By historical precedent, U.S. stocks are long overdue for a bear market. The average bull market since World War II has lasted just 52 months. The current bull market, which started in April 2009, is now more than eight years old.

In the context of today’s uncertainty, you can either flee to safety (and receive dismal returns), do nothing (and get slaughtered), or be proactive and take decisive measures to simultaneously hedge your portfolio and profit.

A few crash-protection measures to consider: pocket profits from your biggest gainers; use stop losses for further stock purchases; avoid glamorous stocks with nosebleed valuations that get fawning coverage on CNBC; invest 5%-10% of your portfolio in precious metals (e.g., gold and silver); raise you portfolio’s cash level to at least 25%; and make sure you’re diversified across sectors and asset classes.

Also increase your hedges allocation to at least 30%. In addition to precious metals, one hedge worth considering is AdvisorShares Ranger Equity Bear ETF (NYSE: HDGE). This exchange-traded fund focuses on U.S. based, mid- and large-cap stocks with low earnings quality, regardless of their brand name or favor on Wall Street. To find these dangerous stocks, HDGE managers scrutinize the income statements to uncover hidden vulnerabilities.

After pinpointing equities with particularly weak fundamentals, the fund shorts them. With net assets of $168.6 million, HDGE loads up on the very stocks that tend to fall the hardest in a correction. Caveat: The fund’s expense ratio is a bit high, at 1.63%.

Regardless, now’s not the time to take fliers on frothy investments. Investors have a tendency to only recognize the red flags of a correction in retrospect, after the damage has been done. Don’t be oblivious, like Mad magazine’s cover boy. Take defensive measures.

 


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Stock Talk

Rick W.

Rick W.

John,
How big of a correction are you guys anticipating? Thank you.
Rick

Donald Leake

Donald Leake

I think a 10-15% correction would be good for the market. We are currently below or at the 50 day moving average for several indices except the DJIA

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