Nobody can predict what will happen in the stock market over the short term, and, yes, the short term in my book is anything less than five years, which for most investors – and, sadly, most investment advisors – is an eternity. (But that’s the subject of another posting.) However, once you get out a bit farther – seven to ten years – research has shown that we can get a hazy idea of what stock market returns might look like.
And they’re not looking good – at least not for American stocks but more on that below.
“Valuations Matter,” Larry Swedroe
Financial research has shown that stock valuations matter over the long run. When stocks are historically cheap, they generally produce average to spectacular returns over the next decade. When stocks are expensive, they generally produce average to disastrous returns over the next decade.
Now, you’ll notice that both cheap and expensive stock markets can produce average returns over the next decade. That’s true. And that’s why trying to time the market based on stock valuations is a fool’s game. However, you’ll also notice that the other adjectives couldn’t be more different. And that’s why valuations matter.
There are a number of popular methods for valuing the stock market. Luckily for us, almost all of them point in the same direction, so I’ll just use one of my favorites and one of the more well-known metrics – Robert Shiller’s P/E 10, also known as the CAPE ratio – to show why I’m concerned.
The Shiller CAPE ratio is based on average inflation-adjusted earnings from the previous 10 years. The aim is to smooth out some of the volatility of one-year price-to-earnings ratios, as P/E ratios can create a distorted view of valuations at extremes. (Everybody get that. If not, check this out.)
Cliff Asness, a hedge fund manager and University of Chicago Ph.D. in finance, found that when the CAPE went above 25.1, the average annual real return, i.e. your rate of return over inflation, the next decade was 0.5%. The worst 10-year real return was -6.1% a year, while the best 10-year real return was 6.3% a year – about the average real return of the U.S. stock market since 1929. In other words, the best case scenario is average.
As you can see, just because the stock market is historically expensive, it doesn’t mean that you’re doomed to low returns. It just means that the odds of getting average or even above average returns aren’t good. The reverse is true if the market is historically cheap.
When the CAPE was 5.2, the average real return for the next decade was 10.3% a year. The worst real 10-year real return was 4.8% a year, while the best was 17.5% a year.
Currently, the CAPE is at 24.9, disturbingly close to the 25.1 figure used by Asness.
Of course, the CAPE is hardly infallible. Indeed, many very good researchers have issues with it. My concern is that many other valuation methods echo the CAPE. No matter which direction you look at the stock market, it appears to be at best a tad expensive and, at worst, dramatically overpriced.
What To Do
So what to do now? First, I’m not saying that investors should change their asset allocation and suddenly get out of U.S. stocks. As I discussed above, even if the stock market is overvalued, that doesn’t guarantee poor returns in the near future. Indeed, the S&P 500 rose dramatically in the late 1990s at even higher valuations. (Of course, the S&P 500 has returned almost nothing over inflation since that time.)
Instead, now might be a particularly good time for investors to do what they should have done years ago, which is to diversify their stock holdings into other areas, such as international developed stocks, emerging market stocks and the various factors. (You can read my posts on “factor diversification” here and here.) Valuations on international developed and emerging market stocks, while not cheap, don’t appear to be nearly as high as U.S. stocks. The addition of factors such as small, value, momentum and profitability also would help to diversify the sources of returns for investors.
Again, I am not recommending that investors move into international and emerging market stocks, and into factors to “time” the market. I’m suggesting that putting between 25% and 50% of your stock allocation (not your total portfolio but the stock portion of your portfolio) into the foreign stocks has always been a good idea and now may be a very good time to do what you should do anyway. Historically, it has also been a good idea to put a part of your stock money in small, value and momentum stocks.
Whether this additional diversification will pay off in the next one, two or five years is anyone’s guess. But over the next decade or two – which, as hard as it is to believe, should be your time horizon – being diversified has always been the best bet.
The other thing that investors can do is have realistic expectations. If you were planning on stocks earning their historic 9% to 10% a year and bonds earning 4% to 5% annually, you may want to consider a back-up plan. What if stocks return 6.0% a year while bonds earn you 2.5% annually over the next decade? For a 50-50 portfolio, that’s a 4.25% annual return, compared to around 7.5% historically.
How would you achieve your financial goals if your portfolio returns are significantly lower than you expect? All of us need to answer that question.
In a sense, it’s always a good idea to prepare for bad weather, but that preparation becomes imperative when we can see storm clouds on the horizon. Of course, they may pass by and cause no harm, but I wouldn’t bet my future on that happening.