What Camp Are You in?

Posted on March 27th, 2013

Are we 4 years in to a 6 to 8 year secular BULL market? Or are we near the end of a 4-year market recovery driven mostly by the Fed’s quantitative easing?
 
While this question is straight-forward, it is by no means a simple question. Answering it is the key to unlocking untold amounts of wealth. In fact, the questions don’t end here. For instance, even if you thought we were at the end of a 4-year recovery, you would need to have a hypothesis on what happens next? Does the market just move sideways or does it decline? If it declines, does it occur sharply or slowly over months or years?
 
We aren’t trying to market time here – just trying to gauge whether our hedges should be modified. Should they be strengthened to have a higher delta for the near-term 6 month window? Or can we stretch them out over 2 years in anticipation of the continued BULL market?
 
Hard decisions to make. I mostly have been in the camp that this market is significantly over-valued when you look at recent earnings power of the companies that make up the market. Look at this chart courtesy of www.multpl.com. It is the S&P 500 PE ratio over the last 140+ years.

CHART: S&P 500 PE Ratio
As you can see, the current multiple of 18x on the trailing twelve months of actual EPS is no where near an all time high. If you ignore the PE multiple spike in ‘08/’09, the highest multiple is near 45 during the Internet bubble of the early 2000s. (Note: the reason you ignore the spike in ‘08/’09 is that financials had significant negative earnings which dragged the earnings levels so low that the multiple was unrealistically low).
 
So, on a PE multiple basis, the current levels are not high on a historical basis at all. These kinds of levels have been seen on a regular basis thru history – over and over again, in fact.
 
A further look at the Shiller PE ration from multpl.com adjusts for inflation and uses a 10-year earnings average – which smoothes out bumps like 2009. On that chart, it confirms again that we have seen several markets in the past with higher valuations than we see now. 

CHART: S&P 500 SHILLER PE RATIO (INFLATION ADJUSTED PE)
So, while I have been in the camp believing a pull back was imminent, I am now giving in that there is a real possibility that we could have 2-4 more years of secular bull market. I give it at least a 40% chance of happening. What does that mean for hedging?
 
For me and our clients, any new money being put to work will have hedges bought with particularly long expirations – think 2 years out if possible. But to be safe, we will counter-balance the long duration with a closer threshold for being hedged – meaning we will set the protections closer to the money. Not at-the-money – just closer to the money.
 
And we will likely look to roll these 2-year hedges with one year to go before expiration – to preserve the time value in them. This is especially important if the market bull continues its trend.
 


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