How To Handle an Expensive Stock Market

Based on all reasonable measures, the US stock market is very expensive relative to where it’s been historically. Investing at today’s levels means buying at high prices relative to companies earnings, cash flow, book value, etc. and implies pretty low future returns. We believe most reasonable estimates for US stocks over the next several years range from 0% to 4% annually, on average.

By some measures, the stock market is even more overvalued than during the late 90’s tech bubble. The chart below shows us the average stock price (relative to revenue) is substantially higher than it’s been at any point over the last 30 years. (source:www.hussmanfunds.com)

What are the implications of all this? Well, in the short term, very little as valuations take a backseat to other factors. For example, investor sentiment can continue to be positive and markets climb higher if the economy and earnings are growing, the Federal Reserve is supportive, etc.

One can also make a strong case that investors will continue to favor stocks with cash and bond rates being so low. The Philosophical Economics blog has a great post making the case that confidence in the network/system and interest rates being near zero can be very supportive of the stock market.

It’s important to remember that as long as cash is yielding zero or something very low, there’s no arbitrage to force asset prices lower, no dynamic to force them to conform to some historically observed level or average.  They can go as high as they want to, and stay as high as they want to, provided investors are able to develop and retain the confidence to buy at those levels.

 

So, the paradox for prudent investors is in knowing that returns will be low in the future (with fairly substantial risk) while accepting the fact that markets can very well go much higher in the near term. What can an investor do?

Well, if you have a substantial portion of your portfolio in US stocks, you can reduce your allocation in favor of other asset classes. Currently non-US stock markets are more attractively priced than the US. Also, adding asset classes that are not highly correlated with the stock market (e.g. treasury bonds, gold, market neutral funds) may help provide some cushion if the markets perform poorly. Finally, having some sort of sell discipline in place to reduce stock market exposure in down markets may make sense for those comfortable with such a strategy.

Read more:

Asset Markets as Banks

Buffet on Valuation 

Jack Bogle On the Stock Market

 

About Michael McGinley, CFP®, AIF®

Michael McGinley has worked in the financial services industry for over 15 years. He is currently a partner at Providus Advisors, an investment advisory firm located in Chandler, AZ.

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