Reasonably Thinking

When I wrote Market Valuation in the summer of 2009, I argued that the US stock market was starting to become overvalued.  I reiterated this point in January 2010 with Guide to Market Valuation (Hint:  It’s Overvalued!).  True to form, over the past 6 quarters I’ve been selling into strength and building short positions.  As the market rose, I obviously took it on the chin.

A brief revisit to valuing the US stock market…

Last week, fund manager John Hussman claimed that the market is 40% overvalued based on average earnings and dividend growth.  Although I believed the market to be overvalued, 40% seemed a bit high—until I started crunching the numbers myself.  S&P 500 earnings ended 2010 somewhere around $84-87 with a P/E of about 15 (downloadable data from S&P).  These earnings are back at 2006-2007 levels during the peak of the housing bubble.  Likewise, the 1.8% dividend yield is pitifully low; this also reflects that stocks are overvalued.

Now let’s consider what has changed since that time:  the Fed’s balance sheet has exploded, the Federal deficit continues to shoot through the stratosphere, and accounting disclosure has become obscured.  Now, layer on this recent quote from The Economist’s Buttonwood “It seems certain that the Federal Reserve will continue to accompany fiscal stimulus with the monetary equivalent in the form of near-zero interest rates and further quantitative easing. The need for such extraordinary measures is an indication of how weak the economy continues to be.”

What we have is a weak economy, a reduction in transparency, and a currency that is being devalued.  With a weak economy, I find it unjustifiable that sustainable earnings are on par with those of 2006-2007.  The flood of money from the Fed, and the Fed’s attempt to induce a stock market wealth effect (cough, bubble, cough), may be the only things keeping air in the equities balloon.

I have no interest in contributing significant funds to something that is susceptible to a significant, abrupt drop.  This is clearly reflected in my allocation below, where my Shorts position is greater than my US Stocks position.  Clearly this has inflicted a temporary pain (to the tune of $3.8k), but given the forecast, I’m perfectly willing to accept marginal losses now in order to protect against and profit from substantial market declines later.

Aside from stocks, other trades have done well.  Notably, commodities vaulted over all indices.  Perhaps the everyday investor missed this.  Everyday househould items, like orange juice, cotton clothes, and coffee, wonderfully outshined stocks.  Clearly, the media isn’t too focused on this either.  Just look at this headline.

In addition to commodities positions, my November currency purchases of Swiss Francs and Australian Dollars were also profitable.

Looking forward, I have a handful of ideas for 2011.  These include long wheat, selling interest rate puts, long staples/short cyclicals, gold stocks, long oil calls, long floating rate bank loans, and long utilities.  By no means will I require myself to follow through on all of these ideas, and some new ones may even come along, but I’m at least trying to tip my hand as much as I reasonably can.

>>>

Appendix

Asset Allocation:  Goals percentage shifted 5% from  US Stocks to Currencies because of stock valuations and a preference for liquidity.  To see last quarter’s allocation, click Performance 3Q10.

Stock trades:  Stock trades were down this quarter (shown below) and were partially mitigated by coin appreciation (not shown).