One of the warning signals I use is flashing. It says you should take important steps to protect your portfolio. Let me explain.
Just six months ago this unique value calculator flagged up a major opportunity to get into shares. Now that same indicator says stocks are overvalued. It’s time to get bearish on the stock market…
The Fed Model gives the relative value between stocks and bonds and has slipped from bullish on stocks to neutral. It gave its most bullish reading in modern history in January, ahead of the recent rally, but has slipped back with frightening pace. We know this by calculating the FTSE 100’s earnings yield (earnings per share divided by the share price) and comparing it with the yield (what you get as a dividend) on 10-year government bonds. The idea is that you should buy stocks when the yield is significantly above the yield on risk-free bonds.
How has it fared so far?
The Fed Model’s winning habit
The Fed model sent a clear Sell signal on European equities in June and July 2007, well before the market finally cracked. Of course, the Fed model’s most famous calls were in the 1987 and 2001 market crashes. Both times this model called the top of the market according to data from ING Research.
Whilst it’s clear the Fed Model made a great call to buy stocks back in January, this opportunity has dulled rapidly. The yields in government bonds have risen sharply. Simultaneously, the stock market has become overvalued. Investors are now not so well rewarded for taking risks. The current risk premium – the amount of extra gain for holding risky stocks over “riskless” bonds – has fallen dramatically to 6.2% from a peak of 9.4% according to Credit Suisse.
While the pace of the fall is unarguably steep, you may wonder what the concern is. After all, the current level is still far above the long-term average of 4.5%.
Are we being too cautious?
Unfortunately, there is more to this than meets the eye...
While the pace of the fall is unarguably steep, you may wonder what the concern is. After all, the current level is still far above the long-term average of 4.5. Are we being too cautious?
Unfortunately, there is more to this than meets the eye...
While, the risk premium is still good versus bonds, the forces that are pushing the bond yield up and making stocks more overvalued have a strong momentum. Bond yields have shot up following the political debacle that culminated in the UK’s credit rating being put on negative outlook by S&P and may still cost the Chancellor his job.
Markets have so far absorbed the massive issuance of new debt, but yields will have to rise to sweeten the offer if investors are to continue buying. Stocks, too, continue to be overvalued. The earnings of most companies are still falling, and their share prices, bizarrely, are still rising.
In summary, the cases for bond yields to rise and stock yields to fall are both strong. These two factors don’t yet make for a sell recommendation, but they do mean you must be ever more careful about the stocks that you buy and how you treat your existing portfolio.
Here’s what happens next – and what you should do now
The analysts will begin to chatter and positive sentiment will begin to erode.
In a sense, stocks being overvalued is not a case in itself for a reversal. Someone has to tell the market that the emperor has no clothes. And that will be our old favourites, the research analysts.
The Fed Model is familiar to the City. When it starts to point in the wrong direction, it cues more and more bearish pronouncements in their analyses. These bearish sentiments will filter right through the market and investors will start to sell their stocks. It may already be beginning.
Absolute Strategy Research is already warning its clients of the potential risk. “We suspect that the biggest risk for equity investors is likely to come from rising bond yields rather than rising PE multiples.” And Credit Suisse is not far behind, saying “the rise in bond yields has undermined the valuation of equities.”
It’s still a way off, and there continues to be good individual stock picks in the market. But it’s clear to us that the one-way profit party of the last few months could be coming to an end. The Fed Model could prove, again, to be the canary in the coal mine.
That means it’s time to consider selling some of those winners or at least putting your best performing shares on a very tight leash. The way you do that is by placing stop-loss orders on winning shares. That way, if they do fall back, as we believe they will, you can lock in profits into your portfolios. Now’s the time to act.
Best wishes,
Theo Casey
For The Right Side
Editor’s recommendation: Theo Casey is the investment director at The Fleet Street Letter. Be sure to read the brand new report that I sent you earlier this afternoon – The "hyper-inflation" time bomb ticking under Downing Street... - it contains further critical advice on how to protect your wealth.
Note: Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Seek independent financial advice if necessary.
MARKET NOTES
Emerging markets at risk of correction
BY SHIVVY ARORA
Investors are pouring into emerging markets...
EM funds have attracted an impressive $26.1 billion of net inflows so far this year. Not to mention the 13 consecutive weeks of gains. And they’re outdoing their developed counterparts by a huge margin.
Take a look at the chart below. It shows the iShares MSCI Emerging Markets Index Fund (ticker: EEM; red line) versus its world index equivalent (blue line) for the year-to-date. These are exchange traded funds (ETFs) which trade like regular stocks, and usually track an index or basket of stocks.
You can see how developed economies have been trailing their less-advanced peers since March. EEM has gained by 28% so far this year while the world index ETF has lost investors 8%.
Emerging markets power ahead
Source: Bloomberg
Three of the main emerging markets in the EM index – China, India and Russia – have been recovering ahead of the US stock market this year. As I write, for the year-to-date, the Shanghai Composite Index is up by 46%, the Bombay SENSEX by over 50% and the Russian RTS Index by a whopping 83%. These compare to a 3% loss from the Dow.
Investors who recognised the growth prospects in emerging markets over that of the US or Europe have done well. But now is the time to be cautious. A substantial pull back in stock markets globally would see EMs take a big hit as the “hot money” runs for the exits.
Emerging markets will perform well when global growth is back on track. But for now, it’s time to be patient and look for a correction before getting in.
Editor’s note: For detailed coverage and investment ideas in emerging markets take a look at Profit Hunter. Chief Investment Strategist, Manraaj Singh, is primed to enter opportunities in India and China, once the market pulls back. Meanwhile, his top recommendation is a “backdoor” way to play the current oil boom. Click here to receive his latest recommendation – about a “price fix” that could supercharge your investment by 288%.
The Daily Reckoning – The Triple Crown of Financial Catastrophes
BY BILL BONNER
London, England
Wednesday, 10 June 2009
What a great time to be an economist!
Yesterday was another dull day in the markets. The Dow was steady. Oil rose a buck. Gold went up $3.
But there’s nothing dull about the economic news. Already, we’ve been able to see things we never thought we’d see. It’s as if our strange neighbours had invited friends, and even some animals, over for a night of fun – and left their curtains open.
So far, we’ve seen a stock market crash and what looks like the beginning of another depression, already marked by the biggest bailouts and nationalizations in history. We’re getting an eyeful! And with a little luck, we’ll probably see a bout of hyperinflation too. Crash, Depression, Hyperinflation – this is the Triple Crown of Financial Catastrophes!
It is remarkable enough that we have been able to witness a genuine market crash. The crash of ’87 barely counts. It sent prices down as much as a third all around the world. But it was a very short-lived affair. Bread put in the oven at the beginning of it was still doughy when it was over. Then, it kept rising for the next 20 years.
The last real crash in America occurred 80 years ago. We never thought we’d have the privilege of seeing another one. Especially since nearly three generations of economists and financial authorities have been working to prevent them. They set up their safety nets and perfected their formulae... Fed monetary policy was thought to be such a finely tooled instrument that it was widely believed that the feds had mastered the business cycle – thereby eliminating the need for crashes or recessions.
When the economy heated up, the feds turned on the air-conditioning – higher rates, stricter credit standards, and even higher taxes. When it cooled down, the switches were thrown in the opposite direction and on came the heat. The economy was supposed to maintain a constant temperature all year round.
With such perfect climate control systems in place, many thought the cold shivers and hot sweats were over. But something seems to have gone wrong...
And now we’re enjoying the show. From one spectacle to the next – you can’t say it isn’t entertaining. But what might keep us from realizing our goal and seeing all three major catastrophes that give economists the willies?
Uh oh... what’s this?
“US banks to repay $68 billion to Treasury,” says the lead headline in today’s Financial Times. “Move marks turning point in economic crisis.”
The banks are now feeling healthy enough to give the feds back their money. All is well, we guess.
And what’s this...?
Read on…
To read the Daily Reckoning in full, click here.
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