After returning 12% in 2016, the S&P 500 is already up 13% midway through September. Over the past five years the S&P 500 has gained around 14.3% annually which is exceptional performance when compared with returns over the long-term. If 2017 remains positive, it will be the ninth consecutive year of gains for the S&P 500. The last losing year was back in 2008 during the dark days of the Global Financial Crisis. Understandably so, many investors are questioning how much longer the good times can last. People often ask me what I think the market is going to do, when will the market start going down, is it time to get out, etc. I typically respond that I don’t know but what I probably should say in these situations is that these are the wrong questions to ask. Many people have an intuitive feeling that the good times can’t roll on forever, and with that I agree. The stock market cannot continue to rise at its current pace indefinitely; yet, trying to predict the top or perfectly time the market is impossible and counterproductive.
We know that the stock market is trading at elevated levels. Any number of valuation metrics including trailing, forward, and cyclically adjusted price to earnings (P/E) ratios are higher than average, and critics would argue that these P/E ratios are all inflated even more so due to the higher than average profit margins in recent years. In other words, if the “E” in the P/E ratio is overstated due to unsustainably high profit margins then the ratios are even higher than they appear. The cyclically adjusted P/E ratio, or the CAPE, is calculated by comparing the current price of the market divided by the average earnings over the past decade, adjusted for inflation. This ratio goes back a decade to smooth out the ups and downs of the business cycle. At the current reading of approximately 30, the CAPE is at one of the highest levels in history. Using data going back to 1926, the subsequent annual returns for the S&P 500 over the following decade with a starting CAPE of over 25 (the highest quintile) is 3.9% per year. There are many valid criticisms of the CAPE, and the point of this post is not to present it as a precise indicator of future returns. Rather, the point is that most equity valuation measures indicate the stock market is trading at a high level relative to the past. I don’t want to sound alarmist, and this doesn’t mean that I think we are on the verge of a crash. Historically high valuations today simply indicate that future returns will likely be lower than those experienced in recent years.
Bond market valuations are also high. Interest rates near the lowest levels in history mean bonds are priced near the highest levels in history. Currently the yield on the 10-year US treasury bond is approximately 2.2% and we know that for a portfolio of bonds with no risk of default, the starting yield is close to the realized return that the portfolio will earn over time. So like stocks, fixed income investors can expect relatively meager returns going forward relative to the past. This makes intuitive sense. If US government bonds, which have no default risk, are priced to return only around 2% annually for a decade, then the return that stocks must provide to look attractive relative to bonds is low. In other words, in a world where the 10-year treasury bond is priced to yield 2.2%, it wouldn’t make sense for the stock market to be priced to return 14% per year.
So that gets us back to the question of what to do. Is it time to get out? Is the market destined to crash? Like I said before, while it is certainly understandable that people would ask such questions, we don’t believe these are the right questions to ask. The same arguments about the market being expensive could have been (and were) made several years ago, and if you had sold your stocks or bonds then, you would have missed gains. We believe the right question is not whether to get in or out of the market or if the market is going to crash; the question is how aggressively should you position your portfolio. With both stock and bond markets valued at high levels, we believe now is time for cautiousness rather than aggressiveness. If the opposite were true, then it would be time to press the accelerator. In practical terms, what might it mean to be cautious? While this list is by no means comprehensive, we believe now is a good time for investors to:
- Examine their asset allocations and adjust them if necessary. For example, if the percentage of stocks in your portfolio has increased in recent years, maybe now would be a good time for a rebalance, especially the closer you are to retirement. Of course, if you sell stocks, you must do something with the proceeds, so doing this would mean allocating funds to lower risk, lower return options such as cash or fixed income. If you are primarily a fixed income investor, now might be a good time to review the interest rate risk of your bond portfolio.
- Reallocate money from riskier equities to the stocks of companies with more reasonable valuations and/or lower operational or financial leverage. This is a way to reduce risk without changing the asset allocation.
- Recognize that returns going forward will likely be muted compared to recent years and take steps to increase savings if necessary to achieve financial goals. Having proper expectations and adjusting savings accordingly is one of the best weapons in an investor’s arsenal.
- Expect and prepare for difficult markets before they arrive. While I don’t think a bear market is imminent, we know with certainly that gut wrenching declines in the market are inevitable over time. With a portfolio of 70% stocks and 30% bonds (for the sake of an example) the worst return you would have endured in the last 90 years of stock market history is -30.1%. Thinking about the potential downside can help you understand how bad it might get and whether that is tolerable. It’s much better to think about these scenarios and come up with a plan before they happen rather than letting emotions get the best of you in the heat of the moment.
- From a personal finance perspective, maybe there are more attractive destinations for your hard-earned capital than the investment markets. It may make sense to retire debt rather than build up your investment portfolio, especially if the interest rate is high. Or maybe now would be a good time to embark on the home remodel you’ve been thinking about. Even if this doesn’t provide a positive financial return, there are certainly benefits to enjoying an updated kitchen. Who knows, maybe you would save money and feel healthier by eating at home more often!
Given the strong recent gains in the stock market and the relatively high valuations of financial assets, now is a good time for investors, especially those nearing retirement, to examine their portfolios and potentially take a more conservative posture. For younger investors, maybe the most appropriate course of action is to do nothing. But even in this case, it is important to have proper expectations. I certainly don’t know what the market is going to do in the coming months, but given the relatively high level of valuations, I’d rather error on the side of conservatism at this juncture.