The next four years in market history won’t be anything like the last four. In the last four years, the market has run up 81%, hitting all time highs just days ago. However, the uncomfortable truth is that the market is expensive now, and investors better square with that knowledge quickly, or we all may pay the price.
Why do I think the market is so overpriced? First, Warren Buffett’s favorite macro metric, the Market Cap/GDP ratio, is no longer lower than 1. At a little more than 1.1, the market is pricing GDP growth into its current value, even in a market that’s deleveraging and has shown stagnant growth, allowing very little room for error. Aside from a quantitative test, however, I personally use the John Templeton qualitative test to find the market’s stage.
Templeton once said, “Bull-markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” Over the past few years, this has been a great market indicator. 2009 was a universally pessimistic year, the beginning of the bull market. Through 2010 and 2011, the bull market grew over market skepticism around a double (or even triple!) dip recession, until finally, today’s markets have matured into all-time highs as major hedge funds have become optimistic about equities. The bull market appears to be at the beginning of its end, so it behooves any investor to prepare.
If you’re convinced that you should get ready for an unfriendly market in the future, I believe there are two things every investor should begin to do to protect their portfolios and prepare to take advantage of market uncertainty.
1. Lower Market Exposure
I don’t necessarily mean increase your allocation to cash (although increasing your cash allocation is certainly one way to reduce market exposure). I personally prefer using various irregular market techniques to take advantage of a possible market top. Short selling, for example, is one technique that can be added to portfolios as markets begin to get restless. Shorting a company with terrible economics like Overstock.com (NASDAQ:OSTK), for example, would reduce your portfolio’s overall long portfolio exposure, and even perhaps add some outperformance.
I believe Overstock.com is worth further research as a short candidate because of its financials and its management. Overstock is an online retailer offering discount sales of, as the name says, overstocked products. The business model isn’t great. For starters, the company is selling products that were already left untouched by consumers when on the shelves, making their product selection relatively unappetizing. Second, the company boasts 18% gross margins and 1.3% pre-tax margins, literally making a penny in profit for every dollar of revenue. Moreover, Overstock.com, Inc. (NASDAQ:OSTK)’s CEO, Patrick Byrne, has shown character traits that no shareholder would be proud of standing behind. According the Business Insider, just 3 months ago Byrne was arrested for bringing a handgun (with 12 rounds of ammunition) onto a plane. While he denied knowing that the gun was in his bag, his actions are questionable to say the least.
After a year in which Overstock.com, Inc. (NASDAQ:OSTK) ran up almost 130%, the stock is down 22% in the last 3 months, perhaps creating an opportunity to short the stock as the market returns to its senses. I would definitely recommend doing further research here, but a company like this, or any other company with weak financials and an untrustworthy management team, might offer a great way to reduce overall long portfolio exposure.