Alternatives when equities are super-expensive

This is a follow-up to the article I wrote last week in E-MorningCoffee entitled “How did we get here: US equities are expensive”. In that article, I discussed the reasons why I believe US equity markets have now reached their highest valuations ever, driven by a confluence of events, many related to the pandemic. If you consider yourself principally a long-term “buy & hold” investor, then perhaps current valuations do not phase you at all. Most institutional investors behave this way, and I suspect a good percentage of retail investors do, too. However, it seems that the pandemic has caused more investors – especially retail investors – to focus on daily gyrations in the market. The strategy of trying to predict the good days and the bad days, and to proactively rotate between winning and losing stocks more aggressively, is of course the modus operandi of hedge funds and actively managed mutual funds. However, this more proactive approach has inevitably also grabbed a larger percentage of the retail investor market during the pandemic. It is very difficult to always pick the right stocks at the right prices and to time the market correctly over an extended period of time, but investors have discovered that it is fun trying in the short-term so long as it is not too costly.

In some respects, the run-up in equity prices since the pandemic lows (S&P 500 is up 96.1% since its pandemic-low close on March 23, 2020) has emboldened investors that are new to equities, instilling a confidence that will likely – at some point – prove problematic. It is a philosophy that feeds on itself. If you see stocks recover from short-term sell-offs time and time again, then the concept of “buying the dip” becomes enshrined in investors’ minds as a viable strategy. This creates a feedback loop that leads to even more momentum. Coupled with FOMO – or “fear of missing out” – retail investors have gone into equities with a vengeance that has looked extremely smart, valuations aside, since the onset of the pandemic. The use of leverage through margin financing and options has also picked up significantly, especially amongst younger investors, which turbo-charges returns when prices are appreciating but has devastating effects when prices decrease.

If you are well-versed in the history of equity price movements, including periods of severe upswings and downturns – some of which have lasted for long periods – current valuations might be making you nervous. I consider myself to be a long term buy & hold investor, and this has served me well because I have generally selected good companies, have reinvested dividends regularly, and have invested steadily in my core names over many years at regular intervals. Like others though, the pandemic and its aftermath seemed to bring out the “inner day trader” in me, meaning I now look at my portfolio almost every day, occasionally making adjustments that have more to do with macro themes than company fundamentals. The question is “have these more frequent trading decisions served me well”? I honestly doubt it although I haven’t really checked – I’ve been afraid to!

Fortunately, one thing I did get right (so far) is to stay long equities since the pandemic because, in retrospect, the cost of shifting out of equities and into most other asset classes would have resulted in a rather significant opportunity cost over the last 18 months. Just because I stayed long equities through the pandemic depths in March 2020 does not mean I was visionary. In fact, I was far from it because I was frightened and nervous like most investors at the time. In fact, I felt tremendous anxiety in March 2020 as the pandemic gripped the world, causing greater macro-economic uncertainty that I had ever seen in my lifetime. Fortunately, I had many years of experience (and just enough mental strength) to sell a small amount of my stock portfolio to increase my cash liquidity on hand just in case, but to leave the rest of my portfolio intact. I decided to ride this through, because – as I had seen following several other severe downturns (albeit never one caused by a pandemic) – equities eventually bounce back. Keep in mind that since 1928, the S&P 500 (dividends reinvested) has delivered an average annual return of 9.9%, much better than BBB-rated corporate bonds (7.1%/annum) or US Treasuries (5 year, 5.0%/annum) (data from Stern School, NYU here). If you want to know what these seemingly small differences in historical returns mean over time, if you had invested $10,000 in equities 40 years ago, your equity portfolio at the end of 2020 would have been worth around $700,006. The same investment in 5-year US Treasuries or in BBB-rated bonds would have been worth only $90,000 or $216,500, respectively.

Still yet, I find myself at the point where I am scratching my head and asking: “how can this one-way appreciation in stocks carry on”? I know the general history of equities and other asset classes, having studied their historical behaivior during periods of both economic growth and recessions. I understand how influential macroeconomic data can be, especially the level of interest rates. I cannot predict the direction of the pandemic, but I can say with some comfort that we have probably seen the worst days from an economic perspective related to COVID-19. The huge amount of monetary and fiscal stimulus will be winding down sooner rather than later, and this will erode the underpinning of artificial – albeit very favourable – conditions in which financial markets are currently operating. What can you do as an investor if you are concerned about valuations?

1. If you want to stay invested in equities for the long-term – meaning you care little about price fluctuations day to day, week to week or even year to year – I suggest that you simply stick with it. You have probably seen 20%+ corrections before, and you will probably see them again. As my wife always tells me, you haven’t made or lost anything unless you sell and realise gains or losses. One slight (and it is slight) alteration you can make if you wish to stay fully invested in equities but want to slow down throwing “fuel-on-the-fire” is to stop reinvesting dividends and temporarily halt periodic stock purchases, setting aside some cash for the inevitable rainy day.

2. Stay long equities but shift your portfolio gradually to less-cyclical stocks and away from momentum stocks, with the former perhaps better known today as “the boring stuff.” Your returns will not be nearly as exciting on the upside, but these sorts of companies will offer you better protection in a downturn because of a combination of the nature of their business and the fact that many pay regular dividends, which provides a cushion to market-driven downturns. Alternatively (or concurrently), you can shift some money from more expensive, higher momentum stocks into stocks that are less expensive, meaning ones that have lower P/E or price-to-sales ratios. In the US, lower valuation stocks include many small to mid-cap stocks. If you are able to look outside the US, many foreign equity markets – including in the UK, Europe and Japan for example – are also cheaper than the US.

3. Stay long equities but hedge market risk. Hedges are essentially insurance – you pay a premium (cash out) and might or might not collect under the insurance. Market hedges will not be perfect unless your portfolio looks just like an index (which it will not), but they can be effective. Examples of hedges include instruments like puts on indices (say S&P 500 puts) or calls on volatility, meaning VIX calls. Of course, for the VIX to work, you have to have confidence in the correlation between a sharp sell-off in equities and high volatility as expressed in the VIX. I have used market hedges like these from time to time since 2019 (before the pandemic) when I started having concerns about valuations. I suspect the hedges have cost me much more than I have recovered, although they did offer me “peace-of-mind” so that I remained fully invested in the equity market. One other tool often used to hedge (or in some cases speculate) involves inverse ETFs, which move the opposite direction of the index you are targeting. These can also come with embedded leverage for a turbo-charged directional move, usually one, two or three times.

4. Write covered calls and / or buy puts on individual stocks in your portfolio. Writing covered calls generates regular income although you are always at risk of the shares being called away if the stock price is above the strike price on the call date. If you write covered calls, you need to be comfortable selling shares at the strike price, meaning you cannot look back with regret. In essence, you are selling insurance on shares that you own. An alternative strategy is to buy puts on stocks you own, which is insurance for which you pay (rather than receive) a premium for downside protection. Currently, I think volatility – a key component of option pricing – is expensive, so that it might make more sense to be a seller (writer) of covered options for the income than a buyer of puts. But these strategies are very different because covered calls enhance income and provide no downside protection, whilst puts – essentially insurance – cost you a premium but provide downside protection. Your preference will depend on whether you want incremental income (covered calls) or downside protection (long puts).

5. Set stop-losses, or at the very least, alerts, on stocks in your portfolio in which you might wish to preserve gains if the shares fall below some threshold. This can soften or eliminate the risk of having gains in your positions disappear if a sharp downturn were to occur. For alerts, you should anticipate in advance how you want to react if one is triggered. For stop-losses, these effectively create capital gains (or losses) on the spot for stocks held in non-tax advantaged accounts. My only caution with stop-losses is that in the market environment we have had since the start of the pandemic, investors have shown a willingness to “buy the dip”, so you could find these stop-losses being triggered on that one “off” day that seems to occur every few weeks. I have had stop-losses triggered on days like that, which several days later did not look so smart. Of course, had I known, I would not have put the stop-losses in place to begin with, but I usually run a few months liquidity anyhow and do not want to have to raise cash by selling into weakness.

6. Reduce your equity exposure and reallocate your portfolio holdings to include other financial assets (rather than simply setting aside cash which currently earns nil). Ideally, these other assets would have a low correlation to equities and would include instruments like corporate bonds, precious metals, commodities, government bonds, cryptocurrencies or other alternative assets. This is deemed a wise strategy by most financial advisors anyway because it can improve the risk-adjusted returns of your portfolio. The balanced portfolio strategy is a cornerstone of the advice provided by most financial planners and wealth managers, who generally recommend shifting their client’s asset allocation gradually from higher risk assets like equities into lower volatility assets like bonds as their clients age, referred to as a “lifestyle strategies”.

7. Sell some or all of your equities, the easiest strategy of all if your fear of a harsh market decline is greater than what you believe will be the opportunity cost of not being invested (or being invested less) in equities. You might miss further upside if you liquidate, but you will be able to sleep at night. And you will sleep especially well when the confluence of factors that have brought us to where we are at the moment begins to unwind. Rest assured, this will eventually happen!

What other ideas might you have? Please add them in the “comments” section below. Use your own personal experiences – we can all learn from each other.

---

**** Follow emorningcoffee on Twitter, and please like and comment on my posts right here on my blog. You need to be a subscriber, so please sign up. Thanks for your support. ****