Author: Martin Pelletier

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There are a lot of good things to talk about when it comes to the stock market these days, as equity markets and especially the S&P 500 and tech-heavy Nasdaq have surpassed all expectations despite the recent blip.

Even bond markets have performed well, pushing yields lower and pricing in multiple cuts, leaving investors wondering how much room there is for further appreciation.

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Overall, all signs are pointing to exercising a bit of market caution over the remainder of the year.

From a valuation standpoint, U.S. equity markets are looking very stretched. The S&P 500‘s price-to-peak-earnings ratio has moved up to 25.7, its highest level since 2000 and 49 per cent above the historical median, according to Charlie Bilello, chief market strategist at Creative Planning LLC.

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The S&P 500 is also trading at 2.9 times sales, nearly double the historical median and approaching its peak valuation in the fourth quarter of 2021. Topdown Charts Ltd.’s euphoriameter, a measure of forward price-to-earnings, VIX and bullish sentiment, is now at its highest level on record.

Looking ahead, we are also entering a period of seasonal weakness. The S&P 500 has fallen 2.3 per cent on average in September over the past 10 years, marking the only month with negative returns, according to calculations by the Motley Fool. The average return in September since the Second World War has been minus 0.8 per cent, with the VIX spiking an average of 10 per cent over the past 33 years.

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At the same time, investors are positioning for economic weakness in other sectors, pushing commodities to their lowest level since the 1930s when measured against the Dow Jones industrial average. Commodities such as WTI oil near-month contracts are down 12 per cent over the past 12 months, while copper near-month contracts are up only six per cent.

Meanwhile, everyone has been herding into U.S. tech, making it among one of the most crowded trades of all time. The five largest companies make up 28 per cent of the S&P 500, the highest in more than four decades.

This is also the case even within the top companies in the index. For example, 45 per cent of Nvidia Corp.’s revenue comes from just four companies, Microsoft Corp., Meta Platforms Inc., Alphabet Inc. and Amazon.com Inc., according to Bloomberg research.

It may not hurt to take advantage of the current level of complacency in the event this monster trade unwinds like it almost did a few weeks ago. Our approach resulted in a bit of near-term underperformance against passive strategies this year, still to the upside, but our conservative strategic positioning has allowed us the luxury of not having to worry as much as others who are all in on equities or even those deploying the traditional 60/40 strategy.

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By preventing large drawdowns and the associated risks of emotion entering the investment decision-making process, investors can increase the odds of meeting their specific financial goals and objectives.

More specifically, we’ve been positioning defensively via our option overlay on our U.S. equity position through put purchases financed by covered calls while continuing to extensively use structured notes, especially as a bond replacement. For example, we just did one on the iShares 20+ Year Treasury Bond ETF, where we get a 14.5 per cent coupon should the exchange-traded fund make any positive gains above zero per cent in 12 months.

We also like Canadian dividend companies such as utilities that are going to benefit from falling interest rates and the spread between their U.S. counterparts. For example, as at last Tuesday, the U.S. Utilities Select Sector SPDR Fund ETF is up 28 per cent over the past 12 months, while the Canadian iShares S&P/TSX Capped Utilities Index ETF is up only eight per cent.

Taking a deeper look within these ETFs in the global infrastructure space, Florida-based NextEra Energy Inc., which encompasses more than 14 per cent of the U.S. Utilities Select Sector SPDR Fund, is up 25 per cent over the past 12 months as at last Tuesday, while Brookfield Infrastructure Partners LP, which is also a holding of ours, is 16 per cent of the Canadian iShares S&P/TSX Capped Utilities Index ETF, but up only nine per cent.

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Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc., operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning. The opinions expressed are not necessarily those of Wellington-Altus.

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