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As Market Correction Looms, Investors Face Three Choices

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Given a near 10% rise in the S&P 500 in the first two and a half months of the year, the equity markets may have gotten ahead of themselves.

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Recently I wrote an article titled Why Investors Should Expect S&P 1600 by the End of 2013 citing how and why the S&P 500 (INDEXSP:.INX) would reach 1,600 before the end of this year and ultimately settle around 1,575 by year-end.

I still believe this to be true. However, given a near 10% rise in the index in the first two and a half months of the year, the equity markets may have gotten ahead of themselves.

Over the past few trading days, the advance/decline ratio has narrowed significantly to indicate a narrowing of market breadth. Moreover, financial shares, which have helped lead the market higher, have begun to slip over the past week.

Here's another data point to consider: the cyclically adjusted price earnings ratio. This ratio's origins come from Benjamin Graham and David Dodd in their (seemingly) timeless tome, Security Analysis. They asserted that one-year earnings were too unreliable and volatile to provide an accurate measure of a firm's earning power. The notion was later popularized by the famed Yale economist Robert Shiller who provided an average inflation-adjusted price earnings from the previous 10 years of data. The averaging of inflation adjusted earnings data blunts the peaks and valleys of corporate earnings.

According to his most recent calculations, Dr. Schiller's ratio now stands at 23.5 compared to a historical average of 16.5 – indicating that shares may not be quite as cheap as they appear. Note that on Black Monday, October 19, 1987, the market's cyclically adjusted price earnings ratio stood at about 17.5, and that on Black Tuesday, October 29, 1929 – which had people jumping out of windows – the ratio stood at 30. (Shiller PE courtesy multpl.com.)


Chart courtesy of multpl.com.

Most strategists agree that corporate profit growth is likely to slow. This means year over year comparisons will look worse. Mathematically, however, it also means the cyclically adjusted price earnings ratio will rise from its current level.

A correction, based on this analysis, would seem to be at hand, and this offers investors three choices: 1) move to cash, 2) move to "new" and undervalued asset classes such as emerging market bonds (which saw record inflows in January and February), or 3) accept the possibility of short-term market volatility while repositioning your portfolio into strong growth companies that demonstrate relatively low volatility.

The problem with the first choice is that with today's "blue light special" interest rates, this all but guarantees a loss from inflation and taxes.

The problem with the second choice -- finding the new, new thing -- is that esoteric asset classes have esoteric risks that are difficult to predict and assess.

For these reasons I favor the third choice, which is accepting the likelihood of short-term losses while repositioning your portfolio toward companies that have demonstrated relatively low volatility, strong earnings, and dividend growth. Examples of equities that fit this bill in the GMG Defensive Beta Fund include: Chevron (NYSE:CVX), Cognizant Technologies (NASDAQ:CTSH), Cummins (NYSE:CMI), Parker-Hannifin (NYSE:PH), Deere (NYSE:DE), and Walt Disney (NYSE:DIS). We will be increasing our positions in each.

Follow Oliver Pursche on Twitter: @opursche.
Positions in CVX, CTSH, CMI, PH, DE.
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