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.
Another way to avoid the risk of traditional market exposure is to invest in misunderstood companies. For example, BP plc (ADR) (NYSE:BP) is a large cap integrated oil and gas company. The company is notorious for causing huge damage to the Gulf of Mexico in what has come to be known as the “2010 BP Oil Spill.” However, since then, BP has made a lot pf progress. They’ve worked with authorities to improve the Gulf situation, and they’ve somehow managed to increase revenue by 26% since that oil spill.
However, BP’s worries aren’t anywhere near over. As of April 1, BP management estimated it could spend as much as $42 billion in clean up, fines, and other liabilities due to the spill if lawsuits don’t go their way. The major civil lawsuit is in court right now, and will take a few more months to settle. However, I believe the market is already pricing in these worst case scenario fines without pricing in future growth. If you adjust for the roughly $13 per share in worst case scenario liabilities, BP plc (ADR) (NYSE:BP) shares are still 12% below their prices before the spill, even as they’ve growth revenue. Moreover, ever since 2011, when prices were actually roughly 10% higher than they are now, famed value investor Seth Klarman has had a sizable position in BP shares. Klarman has generated over 20% returns annually through his Baupost fund, and while you should never blindly follow an investor into a position, his position should definitely pique your interest.
In any case, if finding value is difficult, there is one more thing every prepared investor should do immediately.
2. Make Your Wish List
Every investor should have a stock market wish list. What companies do you wish you could own at lower prices? Making a wish list will allow you to take action and buy these companies rather than sit back in fear when your dream companies’ stocks begin to fall during the course of a bear market. For example, I’ve had Apple Inc. (NASDAQ:AAPL) on my wish list for a while. It’s a company with a strong brand, industry-destroying supply chain management (measured by cash conversion cycle), extremely high returns on equity, and excess cash just waiting to be distributed to shareholders. Moreover, it makes products (the iPhone, iPad, and Macbooks) that I am intimately familiar with. The additional upside in future innovation from rumored products like the iTV or iWatch only increases my love of the company.
Much of the value of Apple as a company is derived from its ecosystem. If you own an iPhone, you are very likely to use iTunes. You’re also likely to have fallen in love with iOS and taken to the iPad or iPad mini. As David Einhorn has said, Apple Inc. (NASDAQ:AAPL) is a software company that sells its software through product cycles. Thus, the value of the company’s ecosystem, the vehicle through which the software is sold, surpasses the value that each physical product alone provides to shareholders. The other day the company fell below $400 per share, an almost 40% haircut in the last 8 months. It trades at roughly 6x earnings ex-cash, even after taking into account the taxes the cash would go through if moved back to the US, and is cheaper than many of its comparables. At these prices, my wish list reminds me of why I wanted to buy Apple Inc. (NASDAQ:AAPL) before it became cheap, and allows me to take advantage now that the price is right rather than remain fixated by the fear that the stock may fall further in the short-term.
However, you should expand your wish list to as many companies as you can possibly find that you would like to own. Choose companies with high growth potential, visionary management, stable revenue, or any other characteristics you’d look for in your dream company. Your watch list should be full of companies at the top of their industries. I personally like Costco Wholesale Corporation (NASDAQ:COST), which with fantastic management and a solid business model and reputation has managed to grow pretax income from $1.7 billion to $2.7 billion in the last four years. Today, Costco is expensive at 23x earnings. Having been to Costco and filling my pantry in bulk with its cheap yet quality products, I can say this price may be fair. However, if there were a market downturn, I would be confidently buying all the Costco Wholesale Corporation (NASDAQ:COST) stock I could get at 15-17x earnings, knowing how much of a bargain those prices are compared to the prices I was getting just a little while before.
By reducing market exposure by taking short positions or an unconventional long positions and preparing for a downturn by making a watch list of the greatest companies available today, any investor should be ready to take on the trials and tribulations of the markets in the coming years.
The article How To Prepare For The Inevitable Market Mania originally appeared on Fool.com and is written by Nikhil Shamapant.
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