Friday, December 19, 2014

U.S. Stocks — Overvaluation Alert

The Covered Calls Advisor uses five primary valuation metrics to get a general sense of whether, at any given time, the U.S. stock market is relatively undervalued, fairly valued, or overvalued. All five of these indicators are now signaling that the U.S. stock market is now overvalued.

1. P/E Ratio — The current trailing twelve months Price-to-Earnings Ratio for the S&P 500 is 19.0, which is 31% higher than the historic average of 14.5.

2. P/S Ratio — The current Price-to-Sales Ratio for the S&P 500 is 1.8, which is 29% above the historic average of 1.4.

3. NYSE Margin Debt — Very close to highest ever historic value.

4. Corporate Profit Margins — Current trailing twelve month operating profit margins are 10.1%, which is two standard deviations above the long term historic average of 6.5%.

5. Total Stock Market-to-Gross National Product — This is Warren Buffett’s favorite valuation indicator of the overall stock market. The total stock market valuation is measured by the total market capitalization of the Wilshire 5000 stock index. This indicator is now at 119.1% which is 2 standard deviations above the historic mean of 71.3%. There has been only one other occasion (during the dotcom bubble in 2000) in the past 50 years when this indicator was so far above the historic average.

The current Overall Market Meter rating for the U.S. stock market is NEUTRAL. But this rating includes macroeconomic, momentum, and growth factors in addition to valuation measures (like those shown above). Today is December 2014 options expiration. Normally, with a Neutral rating, the Covered Calls Advisor would on-average sell 1% out-of-the-money covered calls for the next month (in this case for Jan2015). However, the five metrics above clearly indicate that we are now at an extremely high valuation in the U.S. stock market; so much so that the Covered Calls Advisor’s portfolio strategy will be adjusted to reflect this more cautious outlook. So, positions established for the Jan2015 expiration will be hedged to a greater extent, so that a profit could still be generated even if a market pullback occurs during this next month. The positions will be conservative ones with about 85% moderately deep-in-the-money Covered Calls (and/or short their synthetically equivalent 100% cash-secured Puts) and an approximately 15% short position in the S&P 500 index — ProShares Short S&P 500 Index (ticker symbol SH). The long position in SH was established today with the purchase of 1,000 shares at $21.68 per share.

Please contact me at the email address shown in the right sidebar with any comments or questions.

Godspeed and Merry Christmas,