Monday, March 19, 2018 3:56 PM EDT
The US stock market had a long overdue correction in the first quarter, a response to the concern that the market had become overvalued in the raging post-election bull market. Many sophisticated investors would probably agree that a healthy pullback can propel the market forward in the long run. One of the arguments for that view is that the pullback brings an overheated market back to a so-called bargain level so that more cash will participate. However, how can one identify a market that is truly overvalued? We recommend a close look at the equity risk premium. (Data source: Bloomberg)
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Figure 1. Trailing and Forward S&P 500 Equity Risk Premium Comparison
Figure 1 demonstrates the equity risk premiums in both trailing and forward measures for the past two decades. We define the trailing equity risk premium using realized volatility and use perceived future volatility to calculate the forward equity risk premium. The first takeaway is that the trailing premium is less volatile than the forward premium. This suggests that the market tends to overestimate the future violence of market movements. More importantly, this fact indicates that oftentimes the market turns out to be not as overvalued as many investors have believed. However, overestimating equity risk does not necessarily translate into overestimating volatility. In fact, forward volatility overshoots and undershoots for almost equal amounts of time, as shown in Figure 2.
![](https://gallery.mailchimp.com/d6f020f3bd6a1e2c4eb254e6c/images/716d5365-f2fd-45f3-ae97-bf7e878f5a8c.png)
Figure 2. Realized Volatility vs. Forward Volatility
Now, did the market seem to be overly valued in the month of January? The market itself thought so, according to the forward risk premium. Nevertheless, bearing in mind the evidence that the market tends to miscalculate volatility during significant price movements, we advise investors not to just simply stampede with the herd. After all, panic selling and FOMO (fear of missing out) buying will only dampen overall returns.
Disclaimer: The preceding was provided by Cumberland Advisors, Home Office: One Sarasota Tower, 2 N. Tamiami Trail, Suite 303, Sarasota, FL 34236; New Jersey Office: 614 Landis Ave, Vineland, NJ ...
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Disclaimer: The preceding was provided by Cumberland Advisors, Home Office: One Sarasota Tower, 2 N. Tamiami Trail, Suite 303, Sarasota, FL 34236; New Jersey Office: 614 Landis Ave, Vineland, NJ 08360. 1-800-257-7013. This report has been derived from information considered reliable, but it cannot be guaranteed as to accuracy or completeness. For a list of all equity sales/purchases for the past year, please contact Therese Pantalione at 1-800-257-7013, ext. 315. This report is currently about 1700 pages in length. It is not our intention to state or imply in any manner that past results and profitability are an indication of future performance. This does not constitute an offer to sell or the solicitation or recommendation of an offer to buy or sell any securities directly or indirectly herein. Cumberland Advisors supervises over $2.4 billion in separate account assets for individuals, institutions, retirement plans, government entities, and cash-management portfolios. Cumberland manages portfolios for clients in 48 states, the District of Columbia and in countries outside the U.S. Cumberland Advisors is an SEC registered investment adviser. For further information about Cumberland Advisors, please visit our website at www.cumber.com. Please feel free to forward this Commentary (with proper attribution) to others who may be interested. CONFIDENTIAL: This e-mail, including its contents and attachments, if any, are confidential. If you are not the named recipient please notify the sender and immediately delete it. Copyright and any other intellectual property rights in its contents are the sole property of Cumberland Advisors. E-mail transmission cannot be guaranteed to be secure or error-free. The sender therefore does not accept liability for any errors or omissions in the contents of this message which arise as a result of e-mail transmission. If verification is required please request a hard-copy version. It is important that you do not forward full account numbers, tax identification numbers or confidential personal information via email unless it is password protected Although we routinely screen for viruses, addressees should check this e-mail and any attachments for viruses. We make no representation or warranty as to the absence of viruses in this e-mail or any attachments. Please note that to ensure regulatory compliance and for the protection of our customers and business, your e-mail message is not private in that it is subject to review by the firm, its officers, agents, employees, and by federal or state regulatory authorities including but not limited to the Securities and Exchange Commission.
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