It is often said there are only two things certain in life—death and taxes. While this is true, there is a third addition that is equally as valid—that bull markets, that is to say, multi-year periods of stock market expansion, do not last forever.
While it is generally true that markets rise over the long term, the average bull market in Canada has lasted only 48 months. With the current bull market 74 months old, the TSX slightly off all-time highs, and economic headwinds present, the market is due for a correction. In fact, since 1956, 12 bear markets have occurred, with the average decline being 28%.
The question is—how overdue are we, and how should you react?
How overvalued is the market?
Relating the length of the current bull market to historical averages is one way of determining how overdue a correction the market is, but this method is ultimately flawed, since bull markets typically end because they become overvalued relative to real economic indicators like GDP or corporate earnings.
So, while it is true the current bull market, at 74 months old, is way above the average bull market age of 42 months, this does not necessarily mean a pullback is imminent.
To determine how overvalued the market is, two popular indicators are used. The first is the infamous “Buffett Indicator,” which Warren Buffett suggested to value the overall market. This indicator is a ratio between total market cap and GDP, and is a good way of relating a country’s economic output to its stock market value.
Currently, Canada has a GDP of $1.9 trillion, and a total market cap of $2.5 trillion, giving it a total market cap over GDP of 131%. For Canada, the historical mean is 119%, and since markets have a tendency to return to the mean, the market is overvalued by this indicator. Canada has one of the top six highest figures for this indicator out of the 22 largest countries.
A second widely used indicator is the “Shiller PE ratio.” The Shiller PE is basically a price-to-earnings ratio for the entire stock market and it relates the average inflation adjusted corporate earnings for the past 10 years to the total market cap.
Currently, the Shiller PE for the TSX is approximately 20, which implies the TSX is trading at 20 times corporate earnings. This is above the historical average of 18.5, and once again, this puts the market at risk of reverting to its historical mean, as it usually does.
With both the Buffett Indicator and Shiller PE being above their long-term historical averages, the current bull market being over two years longer than average, and numerous economic headwinds present (low oil prices, reduced GDP growth forecasts, etc.), it is safe to say the market is at risk for a major correction.
What should you do?
Fortunately, there are two things an investor can do to reduce risk. The first thing to do is to invest in high quality dividend-paying companies with a history of increasing dividends. Historically, these types of stocks perform extremely well in recession environments, and during the 2008 crash, the U.S. index tracking stocks with 25 consecutive years of increasing dividends only fell 22% compared to 37% for the total market.
In Canada, Enbridge Inc. (TSX:ENB)(NYSE:ENB) meets this criteria, having increased its dividend every year since 1953, with a predicted dividend growth of 14-16% for the next three years. Stocks like Enbridge typically see less selling due to their strong yields and growing dividends, their stable cash flows, and economic moat.
A second way to protect your portfolio is to increase your cash allocation. While holding too much cash is never wise, holding 5-10% in cash is a smart idea, since it not only reduces downside for your overall portfolio if markets fall, but it also ensures you have resources available to scoop up bargains when they become available. Bear markets and corrections are tremendous opportunities to buy companies at a discount, or average down the costs of your current holdings.
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Fool contributor Adam Mancini has no position in any stocks mentioned.