The underappreciated bull market just keeps on running.
This year, we’ve already seen a ridiculous 40-plus record closes for the S&P 500 SPX, +0.22% .
But that hasn’t stopped a chorus of bulls warning against a potential correction right around the corner.
By now, every investor has heard plenty of arguments as to why this aging bull market may run out of gas soon. But in case you need a scorecard of some of the most damning evidence, author and asset manager Mebane Faber is out with a new research report that lays out the case pretty starkly by digging into four important topic.
Here are four big warning signs he sees right now:
1. The bull market is old. Investing at the end of 2017 “feels a bit like being on mile 21 of a marathon,” Faber writes in the report. Sure, there’s still room to run. But this race has to end eventually.
2. Valuations are elevated. This isn’t a warning based only on one fashionable metric like Robert Shiller’s CAPE reading. “If you look at a basket of common valuation metrics — things like price-to-earnings, price-to-book, price-to-free-cash-flow, and so on — they’re all generally saying the same thing,” Faber says.
3. Sentiment is mighty bullish. Investors are as optimistic as they have been in 30 years, by one measure. That’s noteworthy because irrational exuberance is one of the hallmarks of a downturn.
4. Where’s the volatility? A recent reading of the CBOE Volatility Index VIX, +1.48% set a 23-year low, hinting that markets are complacent and, in the words of the Federal Reserve, “inconsistent with the considerable uncertainty” facing investors in 2017.
None of this means a crash is imminent, said Faber, the chief investment officer of Cambria Investment Management. After all, some of these arguments have persisted for a while and the market hasn’t quit rising yet.
“I like to say it’s the Jay Cutler bull market,” he says, referring to a statistically impressive Chicago Bears quarterback who was nevertheless run out of town by fans and team managers. “It’s a very melancholy, nobody-seems-to-care-that-much-market” despite a track record of success.”
Faber described himself as “a trend follower at heart, and history shows markets can go much longer than people think.” Still, he warned that “right now, trend followers see a yellow warning light” and that the red light of a correction or crash is very likely to follow.
“It could be next month or two years from now, but eventually the trend will roll over,” Faber said.
To read Faber’s research on the current market environment, check out his archive of white papers on Cambria’s website. (Or get the insight directly from him at a MarketWatch international investing panel on Oct. 24 in Los Angeles. If you’re interested in attending this free event, please email email@example.com.)
How do investors protect themselves
Many of these arguments probably sound familiar.
Even if they do, you still may be wondering how you protect yourself against a possible correction. After all, stocks still seem like they are the only game in town.
But Faber warns it’s dangerous when investors only think about how to achieve the biggest possible returns. Sometimes — like right now — it makes sense instead to see a portion of your portfolio as insurance instead of just a reach for big profits.
“Insurance-type of strategies or funds, on their own, are not a good investment just like buying house insurance or car insurance on your own is not a good investment. There’s not a positive return,” Faber said. “But does it make life easier when things hit the fan?”
The idea of insurance is partially about protecting your portfolio from the direct losses caused by a downturn in the market, but also to protect your portfolio from yourself. Countless studies show behavioral hangups and cognitive biases cause even smart investors to do stupid things.
“I would argue that anything that keeps people behaving better and keeping their investment plan in place is a worthwhile cost,” Faber said. “So if you give up a little return at the expense of less volatility or lower drawdowns, it’s a worthwhile investment.”
That’s why Cambria Investments created the Cambria Tail Risk ETF TAIL, +0.07% which is heavily invested in stable U.S. Treasurys and supplements the portfolio with out-of-the-money puts on the broad market to offset any stock declines.
“If you look at the bear markets and the worst months, the best thing to do to hedge is puts — better than gold, better than bonds, better than everything,” Faber said.
And when you consider the extremely low market volatility and the general affordability of out-of-the-money options, the puts purchased by the TAIL ETF are quite cheap these days.
Of course, the TAIL ETF has slowly declined this year as the put options have been on the wrong side of the rally and as Treasury bonds have been incredibly sluggish. But for investors simply looking at the track record of this fund during the good times, you’re missing the point.
Cambria isn’t the first company to try to provide investors some kind of hedging strategy via an exchange-traded fund. The Ranger Equity Bear ETF HDGE, -0.24% tactically short sells what the managers see as weak U.S. stocks. It is down about 10% since Jan. 1 thanks to a rising market, but in a downdraft should perform quite differently.
Another alternative is the First Trust Long/Short Equity ETF FTLS, +0.35% which is tactical about stocks to bet on and which to bet against. This fund has fared better than the other two ETFs, with an 8% return since Jan. 1 as managers have biased toward long positions. But it retains the flexibility to go short if the environment warrants it.
“With insurance like this, the cost of holding in the good times is really where you get dinged,” Faber said. “I would argue that anything that keeps people behaving better and keeping their investment plan in place is a worthwhile cost. So if you give up a little return at the expense of less volatility or lower drawdowns, it’s a worthwhile investment.”
If fact, Faber said he has about 10% of his own portfolio in the fund. “It helps me behave better,” he said.