In other words, which warnings do you take seriously?
First, let’s take a look at the latest indicators flashing red. Then we’ll review the problems with warnings like these. That’ll leave you grumpy about the lack of definitive answers on what you should do. So we’ll turn to an opportunity at the end.
You may be interested in
The Bitcoin Lie
Don’t invest a penny in bitcoin – or any other cryptocurrencies – until you’ve claimed this FREE book.
Discover what could really happen to cryptos in the next 12 months and beyond…
More warning signs of a crash
You can add options pricing to the list of indicators flashing red. Options factor in volatility and the probability of various outcomes. That makes them useful indicators of the future as well as investment tools.
The indicator flashing red in options markets is the price of put options relative to call options. American put options are cheaper relative to call options than they were in 2007. This means punting on stocks going up has never been more popular relative to betting they’ll go down. Put differently, people don’t expect a fall in stocks. They expect them to rise. And they’re most confident since 2007.
By fiddling with the options pricing formula, you can calculate the implied probability of a stockmarket drop. That sounds odd, so let me rephrase. Given the price of options, the probability of a 2% drop in the stockmarket in the next month is below 10%. The previous lows were about 15%.
If you’re confused, just think about options as insurance. It’s cheap to buy insurance against theft in Japan. Because the crime rate is low. In the same way, if it’s cheap to buy theft insurance at your home, you can thereby deduce the crime rate is low in your area. Natural disaster insurance in Japan… well, you get the idea.
Options are similar to insurance. People buy them to protect from a crash, or to profit from a rise. Options pricing is telling you the level of optimism and the lack of fear are at alarming levels. Levels they tend to be at before a crash.
But it’s not just options that are warning you…
The CBOE Volatility Index (VIX) hit all-time lows two weeks ago. It then spiked to one-month highs yesterday in the US as the stockmarket tumbled late in the day. But that was after the Dow Jones Industrial Average posted the fastest 1,000-point gain in history. Both the low in the VIX and the surge in stocks made a correction more likely. They’re further indicators of a coming crash.
There are more obscure records being hit. The number of applicants per job is at record highs in Japan just ten years after hitting a record low. If inflation breaks out in the land of deflation, Japan’s bond market could be riled.
Global initial public offerings (IPOs) hit highs not seen since the 2008 crisis. That’s a bearish indicator because companies like to raise money when their stocks are expensive. It dilutes their existing shareholders less.
Then there’s the highs in US stockmarket valuations. The last two times we reached these levels of valuation, stocks tumbled.
Just as you can deduce the probability of a stockmarket crash from options prices, you can deduce the expected return of the stockmarket from valuations.
If you buy a new car at a 10% discount and try to sell it a year later because your publisher wants you to move to London, you know the usual 19% drop in the value of a new car becomes far less of a tumble. You can deduce about 9% losses instead of 19%.
In much the same way, buying stocks cheaply improves your return. If you buy stocks when they’re overvalued, you’re booking in a loss. At least for a while, given stocks supposedly go up in the long run.
Using such analysis, portfolio manager Dylan Grice explained the current forecast for stocks at a recent Societe Generale conference.
He said the Shiller CAPE valuation model, which I also used above, implies a 2% loss in US stocks over the next decade, after inflation. It’s not as bad as buying a new car, but 2% losses over ten years doesn’t paint a pretty picture for the stockmarket.
The real problem with all these crises indicators is that they tell you nothing about what could happen during those ten years. We could see stocks surge for five more years before they crash. By the time it happens, you’ll be sick of the warnings and go all in on the stockmarket.
Instead of avoiding overvalued asset classes, reverse your thinking. Invest in the best possible investment at any given time. The one with the cheapest valuations.
I’ve just compiled a special report which details some high quality investments trading on extremely inexpensive valuations. You can grab it here.
Always remember, knowledge brings you wealth,