5 Signs Irrational Exuberance Is Back and 2 Actions to Respond

I have written four articles with a similar title since October 2009 and a fifth is now in order (links to the first four can be found in the table below). The signs are here once more -- it's high time for vigilance, not complacency!  

Where did the down days go?
So far this year, the number of up days for stocks (using the S&P 500 Index (INDEX: ^GSPC) as our benchmark) have outnumbered down days by nearly 2-to-1 (37 vs. 20). Even as we near the end of the first quarter, we've experienced only a single day with a daily loss in excess of 1%. Last year, there were 48 such days, roughly one a week. Yes, the macroeconomic environment has improved, but there are still numerous icebergs floating about the global economic ocean that could easily puncture the hull of "unsinkable" portfolios; meanwhile, some investors continue to dance on the deck instead of standing watch.

The VIX Index is at eyebrow-raising levels
As I wrote recently, the VIX Index (INDEX: ^VIX) -- Wall Street's "fear index" -- does have some predictive power with regard to the stock market's short-term returns. Mid-month, the index achieved a five-year low, achieving values not seen since before the credit crisis began. That suggests to me some degree of complacency among investors.

It's not difficult to see why that might be: As we saw above, downside volatility in stock prices has been extremely muted so far this year. My sense is that, in this low-volatility environment, investors and traders extrapolate the recent past into the near future (remember that the VIX Index measures the 30-day expected volatility of the S&P 500 Index). Over the short term, that isn't a bad rule of thumb, but you don't want to extrapolate stocks' smooth, steady rise too far out -- especially not in this environment.

Equity valuations are stretched
As of Friday's close, the price-to-earnings ratio of the S&P 500 using 10-year inflation-adjusted earnings -- the "Shiller P/E" -- is 22.3, which is significantly above its historical average (16.4). Nevertheless, professor Robert Shiller of Yale -- the man who championed this valuation indicator -- told The Associated Press at the beginning of the month that he doesn't believe we are in the middle of a stock market bubble. He went on to say he would choose stocks if given the choice to invest all of his money in stocks or Treasury inflation-protected securities, arguing that "they're highly priced, and they're risky, but they've had a good historic record. And last time I looked, inflation index bonds have a negative real yield."

I tend to agree with Shiller. At current valuations, it's not absurd to trade a certain (small) loss in purchasing power -- 10-year TIPS are currently yielding -0.11% -- for a reasonably good chance of staying ahead of inflation. By my estimate, the S&P 500 will return roughly 2 percentage points annually after inflation over the next decade, and I think there is some room for an upside surprise. However, the framing of the question is highly restrictive and, in that regard, somewhat misleading. In the real world, no one is forced to go "all in" in a single asset class, beginning with just two choices! Just because you pick stocks in that situation does not make stocks a great buy in the real world.

Junk bond yields are crushed
Last October, as the European sovereign debt crisis intensified, the spread of U.S. junk bonds over U.S. Treasuries rose to unusually high levels, ultimately breaking 9 percentage points. At the time, I wrote up a recommendation of a trade to profit from that widening: Long the iShares iBoxx High Yield Corporate Bond ETF (NYSE: HYG), short the iShares Barclays 3-7 Year Treasury Bond Fund (NYSE: IEI). The trade has performed well thus far, as the yield spread has narrowed significantly, falling to less than 6 percentage points (based on the Bank of America Merrill Lynch US High Yield Master II Index). At current yields, neither the iShares iBoxx High Yield Corporate Bond ETF nor the SPDR Barclays Capital High Yield Bond (NYSE: JNK) offers "long-only" investors adequate compensation for the risks they present.

"Europe is fixed for now" narrative takes hold
Investors have developed crisis fatigue and are only too glad to latch on to the "Europe is fixed for now" narrative. Does the European Central Bank's cheap-money program buy eurozone governments time? Certainly, but as the Financial Times' Wolfgang Munchau wrote on March 18:

If you think the European Central Bank's policies have "bought time", you should ask yourself: time for what? Greece's debt situation is as unsustainable as ever; so is Portugal's; so is the European banking sector's and so is Spain's. Even if the ECB were to provide unlimited cheap finance for the rest of the decade, it would not be enough.

By the numbers
The record of my "5 Signs of Irrational Exuberance" article series in terms of their predictive ability with regard to short-term stock returns is weak, as the following table demonstrates:

Source: Author's calculation based on data from Yahoo! Finance. Shows S&P 500 return, from publication date.

It's your turn to act
I'm not by any means suggesting that investors run out and short the S&P 500 in huge size. What I am suggesting is that investors consider the following two steps:

Step 1: Remain focused on the valuations of the individual stocks or asset classes that you own. Trim any positions that have become significantly overvalued.

Step 2: Expect greater volatility. If you've taken care of step one, you should have the confidence to experience a jump in volatility with serenity.