The Risks of a Long-Only Portfolio
As equity indexes again reach new highs, it’s a felicitous time for investors to take a step back and consider whether they are exposed to excessive market risk in their portfolios. The market unfortunately doesn’t ring a bell at the top, but we do know from history that, after two consecutive years of 20%+ gains in the S&P 500 Index, current valuations are quite elevated.
For example, as of the end of 2024, the S&P 500 Index traded at 21.5 times projected 12-month forward earnings, compared to a 30-year average forward P/E of 16.9 times earnings, according to JP Morgan’s research*. The dividend yield is just 1.3%, compared to an average of 2%; the price-to-book ratio of 4.5x is 40% higher than average, and the price-to-cash flow ratio is 46% above the 30-year average.
In fact, going back 25 years, the only time the market was more expensive was in March 2000, when the forward P/E was 25x earnings—on the eve of the collapse of the tech bubble. Since 1980, the average intra-year drop of the market has been 14%, yet the maximum declines in 2023 and 2024 were just 10% and 8%, respectively. Therefore, you might say we are overdue for a correction. Statistically, the market is priced to return only in the low single digits annualized over the coming five years, according to JP Morgan’s analysis.
There is, of course, palpable excitement and some euphoria in the market over the inauguration of the pro-business Trump Administration. This may or may not be justified, but investors should keep in mind that the stock market and economy are two different matters that operate on somewhat different cycles (the market typically looks out six to nine months in discounting the future). For instance, strong growth in personal incomes and the economy, which can contribute to inflation, isn’t necessarily ideal for stocks, especially in an economy starting at full employment, stubborn inflation, and elevated stock prices (see https://blog.longshortadvisors.com/news-insights/the-challenge-of-investing-in-a-full-employment-economy).
How to Navigate the Seas
We don’t know if the market is peaking and set for a sharp decline. We do know that market valuations are extremely high by historical comparison and at levels that imply mediocre future returns. We also know that there is policy uncertainty (which can foment stock market volatility) from the new administration, which includes the impact on inflation and Treasury interest rates of new policies such as deporting undocumented immigrant workers, imposing tariffs on imports, and extending and perhaps even augmenting the tax cuts due to expire at the end of 2025. In addition, investors who have neglected to rebalance portfolio allocations following the strong gains in stocks in recent years are likely overexposed to equity markets.
One way to address excessive exposure to equity beta is to take some of the chips off the table and move them to a long/short equity allocation. This would reduce exposure to the broader equity market while still offering potential upside and mitigating downside risk. The Long Short Opportunity Fund (LSOFX) maintains a net exposure of 50–80%, ensuring investors remain partially invested in the market.
Bonds are another option, but they come with their own challenges—limited upside potential, rising long-term rates, structurally enormous federal government budget deficits, and—considering inflation stickiness—uncertainty about how many times (if at all) the Federal Reserve will cut rates in 2025. As equity investors’ focus shifts from seeking market beta to alpha, a skilled long/short investor can invest in companies with strong fundamentals that are perceived as undervalued and short weak companies that may be overpriced. To learn more about how to potentially navigate the currently challenging market, click here.
