In December the stock market suffered what one may reference as a “waterfall” decline, dropping about 20% during the fourth quarter before staging a dramatic recovery over the past two months. It makes one wonder, what the heck is next?
It’s certainly plausible that the bull market resumes and we see new highs over the next several months. It is pretty clear that the Federal Reserve is concerned about a serious bear market and will likely attempt to do anything in their power to prevent it.
That said, investor sentiment has swung from extremely despondent to euphoric in just a couple months. This means risk is likely high at the moment, at least in the short run.
Regardless, the longer term outlook is very challenging for US stocks. Why? Simply due to the elevated prices one must pay today. Here is a quote from Warren Buffett’s most recent letter to shareholders (emphasis added):
“In the years ahead, we hope to move much of our excess liquidity into businesses that Berkshire will permanently own. The immediate prospects for that, however, are not good: Prices are sky-high for businesses possessing decent long-term prospects.”
Mr. Buffet’s actions are congruent with his words. Based on the report, his firm is holding an enormous amount of cash. He’s likely waiting for lower stock prices as well as higher interest rates.
If you watch the financial media, you may be led to believe that the market is cheap. But it just isn’t true. Below is a representation of the US market relative to GDP (source: advisorperspectives.com).
There are many more charts depicting various valuation methods that we can post here. But they would all tell the same general story. We are near the levels of the 2000 tech bubble in stock prices. In some measures, we are more expensive than that period.
Unfortunately, this information is quite meaningless in predicting short term changes in stock prices! What’s important here is to realize there is a pretty good probability that we see lower prices eventually.
If you had trouble sleeping in December, perhaps it’s time to re-evaluate your allocation now and make sure your portfolio’s risk level makes sense for you, given your circumstances.
A few other considerations:
There are other assets classes that look attractive relative to US stocks. For example, the chart below shows us the prices of commodities relative to stocks.
Having some form of commodity exposure (and bonds) may help if we do enter a legitimate bear markets. (source:marketwatch.com)
It may be tempting to believe that the “all clear” signal has been given with the market’s recent bounce. But it’s important to remember that the market had four 20% fast and furious rallies during the brutal bear market from 2000 to 2003 (not unlike the one we just experienced). Unfortunately, those rallies all failed and the market plumbed new lows. (source:@spomboy)
Finally, a down market can be a blessing for the prepared. We believe that ultimately cheaper stock prices will be available and very rewarding for patient investors as the full cycle runs its course.