Time for some crash protection as US stocks hit record overvaluation

Peter Cooper outlines what the prudent investor should do after returning from their Eid holiday

A trader works on the floor of the New York Stock Exchange (NYSE) in New York. The US stock market’s price-to-sales ratio is currently the most overvalued it has ever been in history. Michael Nagle / Bloomberg

After a whole series of record highs for US stock markets over the summer months, it is tempting to conclude that the bears are permanently beaten in global financial markets and that the bulls will run forever.

However, the study of stock market history shows that only one thing is absolutely certain - it never, ever works like that. Markets always move in cycles, and they go down as well as up.

They are also always at their highest level and most attractive to investors just before they take that inevitable dive into the blue yonder, and make paupers out of many would-be millionaires.

Right now the US stock market’s price-to-sales ratio is the most overvalued it has ever been in history. Higher even than in 1929 before the Great Crash, or the dot-com bubble of 1999-2000.

The respected Cape-Shiller Index of the cyclically adjusted price-to-earnings ratio is also currently only exceeded by 1929 and 1999 levels of overvaluation.

Viewed in this light, stocks are not a place you will want to be when the correction comes, unless you take a very long-term view and won’t need your money for at least another five years.

In fact since June there has been a significant move of investment funds out of the United States and into European stocks - one reason why the dollar has been weakening against the euro, although the concentration of action into a very few mega-stocks has kept the indexes rising.

More than $30 billion was pulled from US stock funds in the last 11 weeks of the summer, the largest such outflow since 2004.

Another worrying phenomenon this summer has been the cryptocurrencies, led by bitcoin. Almost always at the top of any investment boom you will see the emergence of fantastic speculation in what later turns out to be fraudulent and worthless assets.

This time around we have the bubble currencies, more than 800 of them, surging exponentially.

Basically they will only rise in value as long as they can attract new investors and then collapse back to their much smaller original asset bases, wiping out the latecomers.

In 2000 it was the dot-com stocks that performed this function, in 1929 the investment trusts. So what should the prudent investor do on returning from his or her Eid holiday?

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The cautious investor will sell out as much as possible and go into cash and precious metals. The more aggressive speculator should dump bitcoin and its me-too currencies, and consider how best to go short in the stock market.

Cash is an obvious safe haven, though you might want to consider the euro or the yen as the US dollar’s recent 12-year high was another cyclical top.

Gold and silver should also be considered as the classic safe haven. Both did well in 2008 to 2011 when almost every other asset went down in price: gold doubled and silver trebled in that period, admittedly after an initial fall when markets first crashed.

Aggressive speculators will be trying to ride the cryptocurrency bubble until the last moment before it bursts. Beware about selling out too late, although the most important consideration is not to become one of the blockheads who actually believes that this time might be different.

As the great investor John Templeton once wrote: ‘this time is different are the four most expensive words in the English language’. And indeed at the age of 90 he made $100 million shorting dot-coms in the 2000 crash.

You can’t short a cryptocurrency. But that does not mean you can’t short the stock market. There are a number of exchange traded products that allow you to do that, although this is really a realm for expert investors.

Many of these short-ETFs are evil products that will quickly steal your money unless you are spot-on with your timing, or just plain lucky. Not everybody is a George Soros in the making, and in a financial storm you might be more comfortable in a safe harbour than on a surf board.

But I am not alone in being pessimistic about this autumn. October is usually the month when financial markets blow up.

Veteran investment guru Jim Rogers is predicting the biggest crash of our lifetimes, as is ‘Rich Dad’ books' author Robert Kiyosaki who first flagged up a 2017 mega-crash back in 2002.

Top hedge fund managers like Paul Tudor Jones and Carl Icahn, and former IMF economist Mohamed El-Erian, are all sounding the alarm. It’s not true that nobody is saying sell.

The problem is that the alarm bell has been ringing for just a bit too long, and everybody is ignoring it right now. That’s actually a classic top-of-the-market indicator too.

That said, 10 years after the last global financial crisis it is still hard to discern any particular catalyst that would set a market sell-off into motion.

Whacky words from the US President just don’t cut much ice these days. Even the North Korean Crisis this summer was barely taken seriously in financial markets.

The most obvious candidate is the raising of interest rates by central banks. Most recessions can be traced back to this cause. But the Yellen Federal Reserve is so slow and cautious it is hard to imagine anything coming as a surprise to shock markets.

My own probable cause is a big US dollar devaluation as investors weigh up the likelihood of the eurozone moving to catch up with the Fed in ‘normalising’ interest rates.

There is an historical precedent as it was arguably the Plaza Accord on the US dollar’s over-valuation in 1985 that triggered the Black Monday stock market crash of 1987. Maybe this time the ducks will line up a bit quicker before they quack.

Shifts in the value of the world’s largest reserve currency do have widespread consequences and it may not be different this time. It seldom is, as the optimists keeping the faith in global stock markets might care to remember before it is too late.

Peter Cooper has been writing about finance in the Gulf for over 20 years