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Market Realist Chronicles: Protect your investments from a stock market bubble

Part 3
Market Realist Chronicles: Protect your investments from a stock market bubble (Part 3 of 5)

Must-know: Are stocks right now cheap or expensive?

What do past and current market pricing tell you?

Applying this principle to the current environment, the equity market (SPY) gives you 5.5% and the bond market gives you 2.5% (BND). Relative to bonds, equities continue to offer a higher return—but bonds are much safer.

In terms of risk, a 3% spread between bond and equity yields is actually quite narrow, given bonds are pretty much risk-free. A prudent investor should still allocate part of their portfolio to bonds to ensure a safer minimal return.

S&P500 Futures Curve 2014-07-09Enlarge Graph

Regarding equities, there have been several times over the last decade when stocks had an earnings yield of 6%–7%. So why buy into a 5.5% yield? A drop in the equity market would bring yields up, offering investors a better buying point.

In the current fragile environment, the slow monetary policy taper and worrisome overseas news threaten signs of growth. If this earnings season is a disaster and earnings drop 10%, then a price correction of the same magnitude would eat through your yield—at least in the short term.

This means it’s hard for you to paint a bull case for the market. However, this doesn’t mean “get out of the market.” It just means “reallocate in a smart way.”

What key questions should you ask yourself to assess what to do?

Now the questions are:

  • How many investors are thinking the same?
  • When will other investors start cashing out and heading for the hills?

Let’s find out what answers you can expect for these questions.

II. The second step in my framework is to understand what other investors are thinking

The market price itself tells you what investors think the market is worth right now. But it doesn’t tell you their expectations.

You may have heard that looking at the futures market can show you where the market’s going. But futures prices constantly change based on current prices and expectations. Right now, the S&P500 futures expect the market to hit 1,960 points by September or 1,950 points by December. These are pretty much the current price. And that means a 0% return.

At the beginning of the year, the market was expecting the S&P500 (IVV) to reach about 1,820 by September or 1,813 by December. These values were based on the index level at the time, which was about 1,830. That number is off from the current year-to-date return by 7%.

In both cases, though, analysts felt the equity market would fall through December 2016 and then pick up again. If you sold in January based on the futures contract, you would have missed out on the frothy returns this year.

In the next part of this series, I’ll show you a key metric to gauge investors’ intentions.

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