Dollars & Sense August 2014

Q. I’ve managed to stay invested for a long time now and have made good returns. But I’m growing more nervous lately and am wondering what your take on the markets is. Is it over – is the fat lady singing?

A. Yes, that’s the big question on every investor’s mind right now. Unlike the opera, there is no song, no bell, no single indicator for the stock market to signify the end of a bull market. Of course, that doesn’t mean there aren’t clues. Let’s consider three of them.

Let’s start with the big picture and valuations. Markets hit bottom in late 2008 and early 2009 after the Great Recession of 2008. Over the last six years, markets have rallied and valuations are back to “peak” levels. There are lots of valuation metrics, but I would point you to three of them that have proven useful. First, the ValueLine “Market Appreciation Potential” figure is currently 40%. It has ranged from 35% at previous market tops to 185% at previous market bottoms. So it’s currently flashing “top”. Second, let’s look at Nobel Laureate, Robert Shiller’s, 10‐year Price/Earnings ratio. It’s currently about 26x. It’s only been that level (or higher) several times: 1929, 1966, 2000, and 2007. All of these were market tops. Third, let’s look at Warren Buffet’s favorite indicator, “Market Cap / GDP” ratio. It is currently more than 2 standard deviations above its long‐term average. This is similar to the previous peaks of 1966, 2000, and 2007. OK, you get the picture – stock market valuations are very high – at peak levels in fact. That just tells us that there is a higher level of risk.

Next, I would consider momentum and trends. Even when valuations are high, markets can keep trending higher for a long time. It’s only when the trend changes – from up to down – that we would get nervous. For our purposes, let’s define the trend as a long‐term 200‐day moving average. So have any “markets”, “stocks”, or “sectors” rolled over from up to down‐trends? As a matter of fact, yes! Here is a partial list of newly‐turned, down‐trending markets: Germany, France, Italy, Spain, Russia, U.S. Small Cap, Commodities, Int’l Small Cap, Homebuilders, Private Equity, and others. On the otherhand, many key markets remain in up‐trends, at least for now: U.S. Large Cap, NASDAQ, Britain, China, India, U.S. Bonds. So you get the picture – it’s a mixed bag where some markets have already turned down, while others are still holding up. Topping markets are a process; they rarely all turn to down‐trends at once.

Lastly, I would consider investor optimism. While valuation and momentum provide meaningful background considerations, it’s really hope and fear that drive investors to buy and sell. There are several indicators that attempt to measure sentiment but it’s a difficult intangible to accurately quantify. But according to these indicators, after six years of market rallies and some economic recovery, sentiment is fairly optimistic. The question is whether it is peaking and starting to weaken. What could be a catalyst? The obvious are: Russia and Ukraine, Israel and Gaza, Federal Reserve policy, Ebola, and others. Often the final catalyst is something we can’t easily foresee, so who knows.

Given these considerations, you can decide for yourself whether markets are topping and what to do about it. I can tell you that at Ryan Investments we have already begun to trim some of our investments and have raised some Cash. We think the evidence supports being a bit cautious. So, to answer your question, “Is the rally over?”, maybe Yogi Berra’s advice is best, “It ain’t over till it’s over.”

Ryan Investments (RI) is an SEC-registered investment advisory firm based in Aspen, Colorado serving individual investors and non-profits. Our strategy is called “iFolios®” – index fund portfolios actively managed for growth and protection. More information is available at www.ryaninvest.com or (970)429-1100.