“The market can stay irrational longer than you can stay solvent.”

— John Maynard Keynes

While we know stock market predictions to be a fool’s errand, we’re also aware of the importance of monitoring today’s macro developments and various market related metrics. Over the past few months, we've watched the needle on a few key data points move enough out of range that it beckoned more research. And, after further analysis, we've calculated a reasonable likelihood that the financial markets could bring lower than normal returns soon. This is mainly due to very high expectations baked into the system. In our view, balance will only be restored when either the expectations are meet, or are lowered to historical norms. That being the case, we think now it is wise to remain cautious by owning quality stocks, short to intermediate term bonds, and cash reserves. Below, we will provide 3 basic factors we are watching and precisely what we are doing in response to this information.

Factor 1 - High Consumer Confidence: When confidence is high, take note. As the equity markets continue to run, we see indications that investors are now more concerned with the return on their capital, rather than the return of their capital. One measure of this is the consumer confidence index.

Unfortunately, investor exuberance spikes at the worst time.

Factor 2 - Narrow Credit Spreads: Credit spreads are a simple measure of risk adjusted return. The wider the spread, the more likely the markets will yield favorable strong equity returns. Of course, the reverse of this is true as well. Currently, a 10 year treasury yields about 2.4%, while your typical AAA rated corporate bond will pay roughly 2.8%. Thus, a paltry annual rate of 0.4% is our reward for a decade long loan of capital to a corporation. In our view, this is simply not rational.

Factor 3 - Valuations: We own stocks to participate in their future earnings. If these earnings are higher in the future, the value of our investment will likely be higher. If it were only that easy. The trick is to acquire these future earnings at the right price. Currently, the Shiller cyclically adjusted P/E ratio of the S&P 500 is above 29. The few times in history when the markets have carried these lofty valuations, investors experienced low future returns.

Now, in no sense are we intending to come across as fatalistic. In fact, there are many positive indicators brewing in the economy and markets. And, of course, the markets could spike much higher. What we are saying, however, is that statistically there are a few pressures on the markets, and now is a good time to make sure you're aware of your exposure to equities, and are fully committed to staying the course if prices drop. Indeed, the biggest obstacle of investing we all face rests between our ears.

Virtually all great investors know that protecting capital is paramount, and takes priority over profits. Thus we will remain principled to our strategy and focused on the long term. For our client portfolios, we will continue to take action on the following:

Ensuring allocations to equities is at or below their personal risk tolerance
Own underpriced companies that have unassailable business models
Sell drastically overvalued stocks, even if we happen to love the company
Stay principled by not chasing the markets
Rebalance portfolios when prices swing
Buy cheap stocks when the market yields them

Successfully following these timeless principles will tilt the odds of success in our favor. Ultimately, we have to be willing to ride through the storm, if and when it comes. - JML

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Gut Check - Are You Prepared to Stay the Course?