Published On

July 5, 2017

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People love a good party, and over the past year the U.S. stock market has staged quite a bash. Record highs and strong returns are intoxicating, which is exactly why well-seasoned investors may already be thinking about when it will be time to leave the party.

The reality is that the decision of when to pull away from a hot market is a little tougher than deciding whether to walk out of a party before things get too rowdy. There are, after all, costs to moving money to the sidelines and the market is near impossible to precisely time. Fortunately, investing also offers more alternatives than simply choosing between staying too long or going home.

Prices vs. Earnings

Why raise this issue now? Well, the S&P 500 ended April at the near-record high of 2,384.20, up 6.5 percent already in 2017, and up more than 15 percent year-over-year.

Rising prices are a good thing of course – they are a big reason we invest in the first place – but the distinguishing dilemma posed by public markets as opposed to private investments is the extent to which prices tend to become unhinged from the underlying business reality. Which is unfortunate, since prices also have a bigger influence on public market investments than private ones. Think of it this way, while you ultimately care greatly about the eventual terminal value of a private equity or real estate investment, the day-to-day focus is on the revenue and profit-generating ability of the investment because it is not priced daily.

In contrast, while price movements of the S&P 500 are widely reported, the sobering details of company earnings get far less attention. I say sobering because while the price level of the S&P 500 is up 29 percent since the end of 2013, earnings are essentially flat since then. This has pushed the price-to-earnings ratio of the market up to around 24.

The good news is that consensus bottom-up estimates show that S&P 500 earnings are expected to grow by 33.4 percent between now and the end of 2018. However, with prices having already risen by a similar amount while earnings have remained flat, even if companies achieve this impressive earnings growth it will merely mean that by the end of next year, earnings will have more or less caught up with today’s prices.

The Cost of Missing Out

While this disconnect between price movements and earnings gains suggests that the bull market party may be getting a little out of hand, there is a crucial difference between pulling out of a bull market and walking away from a party.

Leaving a party may mean missing out on a good time, but it doesn’t actually cost you anything. Pulling investments off the table can have actual financial costs. First of all, there is the inexorable drip of inflation, meaning that generally any time you are not making money, you are losing purchasing power. Second, market gains tend not to occur at a steady rate, but happen in fits and starts. Missing a hot streak can mean missing out on a few years’ worth of average gains.

The key to handling this dilemma is to think not simply in terms of leaving the bull market party, but in terms of finding a different party.

Finding a Different Party

Here are some examples of how investors can avoid the type of over-pricing public markets are prone to at times without becoming overly conservative:

  • Asset allocation. The most recent TIGER 21 Asset Allocation report shows that on average, our Members have reduced their exposure to public equity over the past year-and-a-half, from 24 percent to 21 percent. However, most of this money has not gone to the sideline ‚Äì the average cash allocation has increased by just 1 percent. The biggest beneficiary in terms of increased allocation has been real estate. Having the flexibility to move among different asset classes according to conditions gives investors more opportunity to remain constructively invested.
  • Country allocation. Among publicly-traded stocks, there is literally a world of opportunity out there beyond U.S. stocks. As important as the U.S. stock market is, having the flexibility to move to other areas of the world can be one way of avoiding periods of overvaluation in any one country or region.
  • Sector rotation. Markets do not move in lock-step, so it pays to be alert for when it makes sense to cash in your investments in a hot industry in favor of those that are more reasonably priced. Certainly, strong price movements may be attributed to areas with strong earnings growth, but at a time when S&P industry sector price-to-earnings-growth ratios range from 1.11 to 4.37, it seems that higher premiums are being paid for growth in some sectors than in others.
  • Style rotation. Whether it is value vs. growth, active vs. passive, or other fundamental style distinctions, public markets tend to go through fads and cycles. Oftentimes, the willingness to walk away from what is popular at any given time can be a key to finding more attractively priced investments.

Over the past year, TIGER 21 Members have made a decisive move towards real estate, while reducing allocations in public and private equity, hedge funds, and fixed income. Only time will tell if these were the right moves to make, but at least these investors are showing the flexibility to leave one type of party without just going home and sitting things out.

Barbara Goodstein SignatureBarbara GoodsteinPresident & CEO of TIGER 21