The stock market climbed the proverbial wall of work in the first half of 2017 — the eighth year of a bull market that started in March 2009. The SPDR SP 500 ETF rallied 10% this year, through June 23, versus 15% for developed foreign markets, as tracked by iShares MSCI EAFE ETF. Emerging markets, or Vanguard FTSE Emerging Markets ETF, gained 15%, according to Morningstar.
The U.S. stock market scaled new heights, defying common wisdom that it’s too expensive and too risky to buy. The stock market is very overpriced when comparing its total value to the U.S. gross domestic product, or GDP. The stock market capitalization-to-GDP ratio is at 133%, according to Guru Focus. It’s far closer to its historical high of 148%, from the height of the 2000 dot-com bubble than its fair value range of 75% to 90%.
The SP 500 trades at a relatively high price-to-earnings ratio of 26 compared to its historical average of 15.
“According to mathematical laws and more than 140 plus years of market history, our market price/earnings (P/E) ratios are very high at roughly 85% above mean valuations,” said Brad Creger, president of Total Financial Resource Group in Glendale, Calif. “Does this mean that we are in for a market crash? No. Can we see a large sustained market rally from today’s price levels? No.”
“When you look at market P/E ratios that preceded the last three secular bull markets (1920 to 1929, 1949 to 1966, and 1982 to 2000) you will notice that P/E ratios were near 50% below the market’s mean valuations,” Creger added.
Given an overpriced stock market, how should investors in exchange-traded funds, ETFs, and mutual funds position their portfolios in the second half of 2017?
1. Hedge Your Bets
Creger recommends investors hedge their positions or invest in funds that do so such as Swan Defined Risk Fund (SDRAX). The fund invests in the nine sectors of the SP 500 index equally via exchange traded funds or ETFs. It hedges its positions by buying puts on the SP 500 to limit downside risk. The puts rise in value when the market falls.
“The result is a fund with an expected 52.5% upside capture ratio and a 13% downside capture ratio,” said Cregar. “This fund will protect account values in today’s dangerously high valuations, yet still provide a decent upside.”
2. Leave the U.S. for Foreign Shores
Daniel Beckerman, CFP®, ChFC®, president of Beckerman Institutional in Ocean Grove, N.J. and Komson Silapachai, vice president of Sage Advisory Services in Austin, Texas both recommend the iShares Core MSCI EAFE ETF (IEFA). They are betting that economic stimulus, known as quantitative easing, in Europe and Japan will juice those markets. Europe and Japan are keeping interest rates low while the U.S. is slowly raising rates and ended its stimulus program more than a year ago. The Federal Reserve raised short-term interest rates by 0.25% in June and is expected to do so again in late Fall.
“This policy divergence should also help international stocks outperform,” said Silapachai, whose firm has $12 billion in assets under management.
Europe is several years behind the U.S. in its economic cycle, which also puts them at an earlier stage of their economic recovery, Beckman contends.
“Although there is not a perfect correlation, QE has certainly been associated with rising stock prices,” said Beckerman, who oversees $65 million in assets. “Europe and Japan are using QE, which was only rivaled by the U.S. program. Those two regions make up the majority of IEFA. Allocating money there is like swimming with the tide or investing with the wind at your back.”
Beckerman prefers iShares Core MSCI EAFE ETF to the flagship iShares MSCI EAFE because it charges an annual expense ratio of 0.08% — a third of the cost of iShares MSCI EAFE, 0.32%. With a turnover of less than 5% annually, it is very tax efficient.
“It also is more broadly diversified since it includes many small-cap companies that fall into the broad international index, which EFA ignores,” said Beckerman.