Market Update – Gold Outperforms, Stocks Still Overvalued

wall-street-582921_1920Now that the dust has settled somewhat after Monday’s incredible market rout, it is helpful for investors to take stock of where we are in terms of equities, bonds, gold and other asset classes and to look at what to expect for the future and how to best position our portfolios.

Stocks undoubtedly had a wild ride over the past couple weeks. The S&P 500 is now down over 6% for the past month, even after clawing back about half of its severe losses from Monday. Year-to-date, the S&P is still down 4%, faring better than the Dow Jones Industrial Average which is down over 7% YTD, but worse than the Nasdaq composite which is still slightly positive for the year.

Gold has been the big out-performer over the last month, up over 3%. Compared to stocks, which are down over 6% in the same period, gold has outperformed by nearly 10% over the past month! As Anthem Blanchard, CEO of Anthem Vault, states:

“Given that gold has been the best performing major asset class in August, it is pretty amusing to see all of the negative reports.”

It certainly has been interesting to see the media continue to be so negative on gold, even as investors are obviously ignoring the pundits. Historically, negative media reports are actually a good contrary indicator for gold which may be forming a solid bottom. The out-performance of gold during this past month also confirms gold’s ability to act as a hedge or dampener to a portfolio which is why it is helpful to always have a small portion of gold as insurance.

On the bond side, we briefly saw the 10-year yield dip below 2% again as traders performed their usual knee-jerk reaction of flooding into treasuries for safety. Treasuries should continue to be a good place to park cash for investors who want to stay out of stocks for now.

Also very interesting is the VIX, or volatility index, which measures the anxiety or fear of investors. It hit a recent high of over 40, a level not seen since 2011. Furthermore, the pop in the VIX from its complacent level of 12 was the biggest increase in its entire history! This shows how sudden the stock market sell-off was on Monday, and how attitudes toward risk changed dramatically.

So where does all of this leave us? As many of you know, it is impossible to make specific predictions about the market and where it will be a month from now or even a year or more from now. However, investors can make informed decisions based on basic measures of valuation and historical averages.

One basic valuation measure for the stock market is the P/E or price-to-earnings ratio. This is a measure of how many times investors are willing to pay for a dollar of earnings from an individual stock or the market as a whole. Looking at the P/E ratio (specifically the 10-year average and inflation-adjusted ratio), we see the ratio is over 25, compared to a historic average of 16.6. As Doug Short notes, this puts us in the 91st percentile, only surpassed by the 2007 peak, the 1929 peak and the tech bubble!

Of course, valuation measures are not timing tools, but they can help investors position themselves for the long-run. The more you pay for earnings when you buy a stock, the lower your potential return over the long-term.

One money manager who has done a huge amount of research into stock market cycles is John Hussman of Hussman Funds. He neatly summarizes the long and short-term drivers of stock markets:

Valuations are the main driver of long-term returns, but the main driver of market returns over shorter horizons is the attitude of investors toward risk…

In this light, valuations are still very high; remember we have only experienced a very small decline in stocks, relative to ‘normal’ corrections, of at least 10%-20%. Valuations have remained high for the past couple of years with the market marching higher as investors’ attitudes toward risk was very low. We now may be seeing the turn in that attitude as the VIX remains elevated at 28 even today, not returning to its previous sanguine levels of below 15!

This past month is a perfect example of what to expect should we experience more market volatility – which, by the way, is very likely as China continues to slow and its markets decline, and as we may see potential confusion over what the Fed may do. Stocks could correct, bond prices will likely go up, and gold will act as a nice hedge, especially if the U.S. doesn’t raise rates or undertake more monetary easing.

The bottom line for you as individual investors will be to stay diversified, and if you are looking to buy into stocks, especially individual stocks, be sure you aren’t overpaying at this time of extreme overvaluation and a potential shift in attitude.

Chris Kuiper, CFA is currently a student and researcher at George Mason University, pursuing a Master’s of Economics. His previous experience includes asset management, investing and banking.