If I Were To Start My Third Hedge Fund…

As the great New York Yankee Yogi Berra once said, “It’s like déjà vu all over again.”

That’s the way I feel about the markets.

I started my first hedge fund in 2002 to capitalize on what I thought would be the collapse of Internet and technology stocks. The sector dominated the market but lacked the revenues to support their valuations. Many stocks were overvalued by an infinite amount as their share value evaporated into dust.

That strategy worked out masterfully – if I may say so myself!

I started my second hedge fund in the fourth quarter of 2007 to capitalize on what I thought would be the collapse of the Housing Bubble. Individuals became addicted to using the equity in their homes to fund their extravagant lifestyle of Cadillac Escalades and a brand new flat-panel TV for every room in the house. The obvious sign that this house of cards was about to implode was when the pace of mortgage equity withdrawals slowed and homeowners could no longer fund their conspicuous consumption.

That worked out even better – sensing a pattern, here?

If I were to start my third hedge fund, it would be right here, right now.

The probabilities of a serious market decline have not been better in years. The stock market remains overvalued on numerous metrics. But unlike the Internet Bubble where market valuations were skewed by a few wildly overpriced stocks, everything is now overvalued.

There is nowhere to hide.

Since 1966, the median price-to-sales ratio on the S&P 500 has never been higher at 2.4x. Never. For perspective, the ratio was 0.80 during the market lows in 2009. That’s a massive surge in the valuation in equities relative to revenue over that period of time.

Meanwhile, profit margins are topping out. Expectations are high but the earnings required to meet those expectations are getting tougher to generate. But, those earnings are being priced dearly too. The median price/earnings ratio on the S&P 500 is 24x. That a level that as only been eclipsed by the Internet Bubble.

Finally, a little-known valuation indicator invented by Norman Fosback – which has called major market tops and bottoms – is the average price of the 25 cheapest stocks in the S&P 500. When stock prices were completed decimated like they were in 2002 and 2009, this indicator was flashing major buy signals.

Now, it’s as high as it was during the Internet Bubble and much higher than the Housing Bubble. I know people have short memories, but try to remember how many stocks fell 90% or more in both of the last two crises. The higher they go, the harder they fall. You don’t want to get caught in the bloodbath.

Individual investors are as optimistic about the markets as they have been in 30 years. After the presidential election last year, a surge of money flew into equity related exchange traded funds. That continued until recently when the pace of buying fell 50% over the past four weeks. Are buyers tired?

Corporations have also been a big source of fuel for the stock market in recent years. But, their buy-backs are starting to slow. Are they running out of fresh powder to prop up their earnings per share and stock prices?

While I’m primarily a short seller, I am not a permabear. I do, however, think it’s much better to take the opposite side of the trade from the general public because it’s investing very late into this cycle. I’ve seen this movie before. It’s a horror film and it always ends badly.

In Forensic Investor, we’re heavily positioned in a defensive posture. A couple of early 2017 trades were even booked at triple-digit annualized returns. I’ve taken advantage of the overvalued and overbought market conditions to top up other short trades to full position size as the fundamentals have worsened and the technical picture of these stocks has deteriorated.

2017 really could be the best opportunity in nearly a decade to be heavily short the market. Either way I think it will be a wild ride. Buckle up!