What to do when Valuations are High? By David Merkel, CFA of AlephBlog
A letter from a reader:
What would you recommend for a long only equities portfolio?
I too think the market may be overheating, but as always, it’s impossible to tell when the party will end. I would have said the same thing last year this time as well.
This is what I am doing now:
- Cash is presently 16% of my portfolio. I let that fluctuate between 0-20%. I try to be fully invested during crises, and build up some cash when valuations are extended. 16% means valuations are high, but they could get higher — we aren’t at nosebleed levels.
- I have more invested in foreign companies than I normally do. Around 40% of the portfolio is in foreign companies, which are at present undervalued relative to similar US companies.
- Emphasize companies with strong balance sheets, in industries that will not go away.
- I own cheap stocks. The median valuation of the stocks that I own is around 10x earnings, and 1x Net Worth (Book Value).
This isn’t sexy, and if the market roars ahead, my clients and I will underperform. But if there is a reason that emerges that causes the market to fall, my clients and I will do better than most.
I take more risk when the market is in the tank, and less when everyone thinks things are great. This is particularly true when policymakers like the Fed are triumphant over high valuations, and low yield spreads.
This is a time to take less risk, in my opinion, but not a time to take no risk.