Archive for October, 2017

What To Do With An Over-Valued Market

Sunday, October 29th, 2017

NASDAQ CrashesDouble click on any image for a full sized view

I have been very skeptical about this market for a very long time. With valuations stretched above the 95th percentile and complacency running rampant with investors, professional and individual, the risk of being in the market is high.  However, nothing says that this situation cannot go on for a long time into the future before stock prices revert to the mean.

My clients’ cash equivalent allocations in their portfolio are at their max level allowable by policy, so I have been working on booking profits in some high beta holdings (ie, the more volatile ones that have been screaming higher) and moving into things that have been beaten down or haven’t participated in the recent run up, like retail.

I now have a market weight allocation in retail in client accounts, but to get there I had to buy things like Tractor Supply (which I initially had a loss in but now a nice profit), TJ Max, Ross Stores, and Home Depot – companies that seem to be able to weather the Amazon juggernaught.  In income accounts, I bought a couple of companies that were smashed by the Amazon-induced retail bear market, Kohls and Nordstroms (Kohls I have a nice profit but the headline news in Nordstroms has kept that one down). However, I don’t think that is enough to keep portfolio values up if we get a solid correction in the momentum tech companies. So I wanted to share the next step in the strategy I am beginning to put into place.

When we went through the 1999 stock market melt up with the NASDAQ stocks hitting unimaginably high P/E valuations, one of the things I did to prepare for the inevitable fall back to earth was to pick an asset class or industry that was just the opposite from the momentum dot.com companies in terms of being in a bear market while the dot.coms were in a bull market.

In analyzing the dot.coms, you saw that people were throwing money at concepts that had no tangible value. The most opposite asset class or industry that I could come up with was the oil industry. It had been going through a mega bear market with oil dropping to $10 a barrel and companies going out of business. I started to accumulate oil companies very cheaply and reducing tech sector exposure.

By over-weighting the energy sector, when the crash happened, my clients portfolios were protected by the rush into deep value investments like oil companies. By maintaining the overall equity allocation, they were able to participate in the upside during 1999 until the crash in 2000, but because they were in the opposite industry to tech – an industry that had already been in a bear market – they were able to recover from an initial market-wide sell-off while the tech investors continued to be underwater.   You can see the chart below comparing the performance of oil to the NASDAQ from 1999 to 2006.

$WTIC

Today, we have the mobile Internet companies, the cloud companies, and the e-commerce companies that have skyrocketed in valuation. At some point we will need to reduce our exposure to those industries and invest in the opposite industry. Since the Ag industry and commodities have been in a bear market since 2011, it is a natural place to begin – take a look at the graph below.

DBA

I added a 1% Potash position this week to client accounts to begin our move to overweight the Ag industry. I will also likely start a position in the commodity fund DBA and begin to search for other suitable investments that have been left behind.

Are there other similar industries to Ag? Well, energy seems to be a viable candidate again:

$WTIC2

Maybe this is finally the time for the “Scarcity of Water” theme to play out, too. Given all of the droughts around the world, I thought it would be a winner – but until earlier this year when my research came across he company Xylem the theme just wasn’t playing out as I thought it would.

The mining industry also seems to fit the bill.

minimg

Anyway, I understand this is a contrary idea, but since it has worked for me in the past and the current momentum push higher reminds of the dot.coms, dusting off the old invest-in-the-opposite playbook seems as wise as anything else that allows us to stay invested but reduces risk.

Being prudent and protecting hard won gains is critical to long-term investment performance.  Its not the end of the world if the market goes down, but managing through the ups and downs of the investment cycle is always better than being caught by surprise with a huge down swing if you haven’t prepared for it.