Investors need to be prepared for a 10% to 20% correction

by Dan Niles
17 May 2017
CNBC

At the start of each new year, there is one thing I hate doing above all others: Paying my home insurance. I always wonder, why on earth do I do this? I have never had any use for it — ever. Then last year, an illegal campfire was built in Garrapata State Park. We could see the flames from our home. By the end of it, that fire had burned 132,000 acres and became the most expensive wildfire in United States history.

That is how many people have approached the current bull market, which has been going on for eight years — there's no need for portfolio insurance, right?

With a return of 255 percent since the S&P 500 bottomed at 677 on March 9, 2009, the correct strategy in hindsight would have been to borrow as much money as you could and put it all into a long only S&P index fund. In hindsight, there was no need to worry about the European debt crisis, China currency devaluation, oil market collapse, or Brexit vote. The recoveries were always swift with new highs not far behind.

As stocks continue to climb, this 98-month-old bull market seems to have the legs of a youngster. This is the second oldest bull in history. How long did the oldest bull market last? It was from October 1990 through March 2000, a whopping 114 months. Unfortunately, that ended with a 49-percent correction over roughly 2 ½ years. During the most recent full economic cycle that started in October 2002, the bull market lasted 60 months but in the span of 17 additional months, the market lost 57 percent during the correction. The S&P was actually down 13 percent on a price basis over the full economic cycle as can be seen in the table below.

Now many of your reading this may say "Who cares, Dan? If I had held on through the downturns, I made back what I lost and then some." While this sounds good in theory, how many of you actually didn't sell when it looked like the world was headed into the second Great Depression and banks were failing? Did you think the government would let Lehman fail?

The length of the current bull market is even more concerning when combined with the valuation of the market. For example, the Shiller S&P 500 cylical-adjusted price-to-earnings ratio (CAPE) which is based on average inflation-adjusted earnings from the previous 10 years is at 29x versus its average of 17x. But this is higher than at any time since the time periods surrounding 1929 and 2000. Looking at just this year, S&P 500 companies trade at an average price-to-earnings ratio of 21x times last 12 month earnings compared to a 10-year average of 16.5x.

On the positive side, unemployment is low, interest rates are low, and the housing market is strong so the next recession doesn't seem near. Multiples can always go higher and it would not surprise me if stocks climb another 5 percent to 10 percent higher over the next six to 12 months if tax reform or infrastructure spending are passed. I remember stocks looking overvalued exiting 1998 and then the Nasdaq went up 86 percent in 1999, powering a 20-percent increase in the S&P. Much like the New England Patriots coming back from a 28-3 deficit to win the Super Bowl, anything is possible.

However, investors need to be aware that, at these multiples and the age of the current bull market, that the next likely move of 10 percent to 20 percent in stocks maybe lower, not higher. The problem is, most of the time that crystal ball is not handy and you do not know exactly when the next market wildfire is coming.

•     "Much like the New England Patriots coming back from a 28-3 deficit to win the Super Bowl, anything is possible."
  

As it turns out, my home was safe from that wildfire but underinsured. I will be upping our policy. In good times, it is easy to get caught up in trying to obtain everything. In bad times you realize you do not want to lose everything. Only time will tell how long this bull market can last but I can guarantee, you will want insurance when it ends. With Central Bank rates today near all-time lows and their aggregate balance sheets at all-time highs, governments won't be able to be the insurance policy they once were in 2001 or 2008 once the current bull market ends and the next recession/correction begins.

Commentary by Dan Niles, founding partner of AlphaOne Capital Partners and senior portfolio manager of the AlphaOne Satori Fund. Previously, he was a managing director at Neuberger Berman, a subsidiary of Lehman Brothers.