Jeremy Grantham is the founder of GMO, LLC, a Boston-based investment management firm. A lot of people pay attention to his market commentary. In his Q3 letter to shareholders, he made some interesting observations about the stock market.
Grantham bases his latest analysis on the notion that the stock market is overpriced right now because of various cycles of stocks moving up or down, related to something he calls The Presidential Cycle. He believes that the if the S&P hits 2250, which is about 9% from its present levels, the market will be in a bubble from which it will inevitably crash.
Here’s a snippet.
“Regular readers know the score: +2.5% a month for the seven months from October 1 to April 30, in year three on average since 1932 (a total of +17%). This is now the 21st cycle. The odds of drawing 20 random seven-month returns this strong are just over 1 in 200 according to our 10 million trials. But 17 of the actual 20 historical experiences were up and the worst of the three downs was only -6.4%, so the odds of this consistency plus the high return would be much smaller. The remaining five months of the Presidential year have a good but not remarkable record, over .75% per month, but the killer here is that the remaining 36 months since 1932 averaged a measly +0.2% a month!”
I view this analysis as being utterly valueless for the long-term diversified investor. If you’re a trader, then you jump in and out of stock as you see fit. Grantham’s kind of “cycle”-based prognostication should not ruffle your feathers one bit, especially because we’ve heard it before.
As a long-term investor with a highly diversified portfolio, you should not be bothered by predictions, reversions to means, or actual crashes. You have money invested across a variety of sectors and asset classes. You hold some cash to take advantage of such crashes to buy stocks on the cheap. And you stay cool.
For those of you interested in hedging your portfolio if you feel the market is getting wildly overpriced, here are two thoughts.
First, replace you market cap-weighted S&P 500 index ETF, such as the SPDR S&P 500 ETF (NYSEARCA:SPY), with the Guggenheim S&P 500 Equal Weight ETF (NYSEARCA:RSP). Guggenheim holds stocks in the S&P 500, but rather than being weighted by market capitalization, it’s equal-weighted, meaning each of the stocks has a much more equal effect on RSP shares than they do in SPY.
By using an equal-weight ETF, you smooth out the volatility of the index better than if it were cap-weighted.
You will still lose money in a crash, but not as much, as the equal-weight ETF loses less than the SPY by a substantial amount in bear markets.
Second, buy the ProShares Short S&P 500 (NYSEARCA:SH). It’s as simple a hedge as it gets. It shorts the entire S&P 500 index. You can buy it, effectively permitting you to “go long a short position” without actually having to establish a short position in any stock or index.
The great thing about the ProShares Short ETF is that you can hold as much of it as you wish to hedge a specific amount of your portfolio. For example, if you own $10,000 in stock, and you are worried about a 20% correction, you could completely offset that correction by investing $10,000 in ProShares stock.
So if Jeremy Grantham is right about the coming crash, that’s how you fortify your portfolio.
This article is brought to you courtesy of Lawrence Meyers from Wyatt Investment Research.