Five things to do in preparation for the next bear market

Summary

Like any other traded commodity, stocks are subject to the laws of demand and supply. Currently, equity markets remain in a state of excess demand over supply, which largely explains why investors continue to tolerate excessive valuation multiples.

Higher bond yields and excessive valuation multiples have rendered equities far less attractive versus bonds, causing the equity market to lose a major However, it continues to rely on another pillar, namely excess liquidity. Until that other shoe drops, we are not ready to call the end of the bull market.

Like all other good things, this aging bull market will eventually see its final days. Therefore, we are advocating five precautionary measures in anticipation of this inevitable outcome. Please read on.

You know there is a problem when the market dynamics that drive the bull market start to change. So are we there yet?

For sure, high bond yields and excessive valuation multiples have rendered equities highly vulnerable. But that does not necessarily mean that equities are ready to collapse. Another major driver of the bull market is, in our view, excess liquidity, and that is still alive and kicking. Until that other shoe drops, we are not ready to call an end to the bull market. At this point, we are only heeding the warning signals.

It's all about demand and supply

Stocks are traded commodities, i.e. subject to the laws of supply and demand. And what has driven the equities bull market since 2008 is demand, huge demand, versus waning supply. However, in the past two years, we have seen several changes that would inevitably cause demand for equities to drop. That notwithstanding, we have reasons to believe there is still excess demand over supply.

Shrinking supply

You must have noticed that IPO's have been rare. For several years now, the supply of new shares issued to investors has been very limited. To the contrary, companies have been using liquidity and cheap bank debt to buy back their shares. It is estimated that, since 2008, US corporates have bought back some 17% of their outstanding shares.

Incidentally, many people have drawn comparisons between this bull market and the dot.com bubble of the late nineties. There are many similarities for sure but there is one key difference that distinguishes this current bull market from the dot.com bubble. Back then, IPOs were flooding the market with supply of new shares. Now, the exact opposite is happening.

Strong demand

Measuring demand for stocks is a bit more complicated but let's give it a shot. To keep things simple, we will restrict this analysis to two main drivers of demand for stocks, namely valuation and liquidity.

Valuation

Like many other things that you buy, your demand for stocks is impacted by valuation: if something is attractively priced, you buy it. And this is where things have gotten a bit tricky for stocks: the asset class is no longer attractively valued by historical standards. One gauge that we can use is the earnings yield (which is the inverse of the P/E ratio). Currently, The S&P 500 earnings yield (on a trailing basis) is roughly 4%. This means annual corporate earnings represent an average return of 4% on total share prices. This low earnings yield is equivalent to a P/E ratio of 25 times. Historically, this indicator has ranged between 6% (equivalent to a P/E ratio of 16) and 8% (equivalent to a P/E ratio of 12). What makes things worse, is that the US 10-year bond yield is now hovering around 3%, which leaves us with a risk premium of no more than 1% for equities. With Based on that, a reasonable equity investor has no reason to feel adequately compensated for the risk.

Following the rule of inevitable reversion to the mean, stock market valuations are bound to revert back to their historical range. The question is obviously when. And this is where the second important driver of demand comes into play.

Liquidity

To be able to buy anything, you need purchasing power. And for equities, purchasing power comes in the form of liquidity. This is the other shoe that is yet to drop. Excess liquidity is so powerful that it has the capacity to drive the market into over-bought, over-valued territory, for long periods of time. In our view, this is what explains today's excessive valuations. Of course, people talk about healthy economic growth and robust corporate earnings as major pillars of support. Still, we believe this has become of secondary importance, simply because a P/E ratio of 25 is hard to justify. The primary driver of this bull market is now excess liquidity.

Measuring liquidity is difficult. Money supply has now taken so many forms that even central banks can no longer measure it with any degree of precision. But what we know for sure is that since 2008, major central banks of the world have generated obscene amounts of liquidity. This process has been referred to as Quatitative Easing (QE). Between 2008 and now, central banks have spent trillions of dollars purchasing bonds and (to a lesser extent) stocks from the market. And we all know that when central banks buy assets, it is tantamount to printing money (albeit nowadays electronically). The idea is that this additional money, put in the hands of investors, would serve to stimulate the respective countries' economies. What has happened, however, is that much of that liquidity has been used for investing in stocks. And that's what explains why investors continue to buy stocks, notwithstanding high P/E ratios. All this money has to be invested somewhere. Investors follow the rules of asset allocation, i.e. they always allocate their investment among different asset classes. Thus by default, , much of the liquidity had (and still has) to be put in equities.

When (or if) QE ends, the negative impact will be significant, but this is yet to happen. Various QE programs have been significantly scaled down, or even ended, but massive liquidity is still being injected both in Europe and Japan. In summary, the amount of financial assets purchased by central banks worldwide has gradually dropped from a peak of approximately USD 150 billion monthly in 2015 to some USD 75-80 billion in 2018. Economic theory stipulates that the actual amount of money generated by such purchases is several multiples of that number (this is referred to as the money multiplier, but we will not get into that here). Such new money being created every month, although significantly reduced, is still excessive.

To put things in perspective, and to give a sense of this process magnitude, we have summarized in a separate link the size and timeline of various QE programs launched by various central banks worldwide. We believe this summary will help us all monitor this important indicator of market liquidity, which has also been a major driver of this extended bull market. Click here to read it and stay tuned for future updates.

What should you do in the meantime?

Although it's good to have a view of where the market is heading, this does not mean we should bet the farm on it. Those who have been with us for some time know that this is not how we manage portfolio risk. Portfolio risk management is all about possible outcomes and probabilities, so one should always be prepared for the possibility of being wrong. Given we are now navigating in choppy waters, and considering the extent of market over-valuation, the next bear market will hurt and therefore one has to be prepared for it. So here are a few considerations:

First, stay invested, because one always has to have exposure to equities. However, never bite more than what you can chew. By that, we mean never invest in equities any money that you might need in the near future. This will help you avoid the painful outtcome of having to liquidate your investments at a loss. On that, we have recently published a detailed article entitled "Two key numbers you need to decide how much to put in equities".

Second, try to stick to lower risk funds. The FundScope website is full of exclusive (and free) tools that measure mutual funds risk. One important measure is how each fund has behaved in the most recent market setback. On that topic, have a read of our recent publication.

Third, as controversal as this may sound, reduce your exposure to index funds. Index funds are the worst performers in down market periods. Although timing is unpredictable, this bull market will end one day and when it does, losses will be significant.

Fourth, increase your exposure to value-oriented funds, particularly dividend funds. Those tend to be less over-valued and less volatile during corrections and bear markets. Also, because they pay dividends and are less over-valued, they tend to recover their losses earlier. Consider that over the past two years, most of the market appreciation has been accounted for by a handful of US technology stocks (e.g. Amazon, Facebook, Google and Netflix) and some industrials. Such sectors are way more over-valued than others such as financials, energy and materials. Therefore, we anticipate the over-valued sectors to be hit harder.

The problem here is that many funds label themselves as value funds but behave totally differently in real life. To differentiate the true value disciples from the pretenders, FundScope has an exclusive tool that measures each fund's similarity with both value and growth indices. A true value fund must have higher correlation with the value index than correlation with the growth index. Check out this powerful tool by clicking on the "Similarity Analysis" tab of our Mutual Funbds Snaphots menu.

Fifth, keep a healthy exposure to Canada. True, the Canadian market is a tiny fraction of global equity markets but it currently offers a significant advantage: it's less over-valued than the US market.