Stock market valuations are at historical highs and we are more than nine years into the current bull market. It stands to reason that the bull market won’t continue indefinitely. So, not surprisingly, investors are voicing more frequent concerns about high stock market valuations and what that could mean for them going forward. Implicitly, investors are concerned, not just about the objective fact that valuations are on the historical high side, but rather that, as a consequence of these high valuations, we’ll likely be faced with an inevitable market crash. So, what should investors do?

The first step is to separate what we know from what we don’t. Here’s what we know:

Valuations are high relative to historical averages

According to one well-known valuation metric, the Cyclically Adjusted Price-to-Earnings Ratio (CAPE Ratio) or P/E 10 ratio,[1] the U.S stock market, as defined by the S&P Composite Index, stands at 33.18 times 10-year earnings, almost double the long-run average of 16.9 times.

Source: Professor Robert Shiller at http://www.econ.yale.edu/~shiller/data.htm – 9/11/18

 

Now that we have verified that valuations are historically high, what’s next? Does that mean a market crash is around the corner? Unfortunately, all the CAPE P/E 10 model has shown is that historically high valuations are associated with lower future long-run returns and vice versa. It doesn’t tell us the form of the lower returns. By form, I mean to say that even if we knew for certain what the average annual return would be for the next 10 years, which we don’t, that still wouldn’t help us trade our portfolios to deal with high valuations.

Let’s look at a simple numerical example. Assume that long-term historical returns have averaged 10% per year and, based on current valuations, we know the market will return 6% per year over the next decade[2].  Even with perfect foresight about average returns over the next decade, we still don’t know how we get to that 6% per year.  We could get exactly 6% a year, year after year for 10 years. Or we could have double-digit returns in years one through nine and then terrible results in year 10. Or we could have a meltdown in 2018 and then good returns for the next nine years. The underlying problem is that valuation data does not give us any insights into stock market patterns.

So where does this leave investors concerned about market valuations? Here are five do’s and don’ts to consider:

  • Do not market time: Despite the attractiveness of the idea of selling out of the market right before it falls, moving to cash and then buying back into the market at the bottom, there is little evidence that anyone can add value using this type of strategy. A sense of the precision needed to successfully market time might also help deter you. During the 28-year period from 1990 – 2017, the S&P 500 delivered a compound return of 9.81% per year. During the same period, risk-free one-month U.S. Treasury bills returned 2.77% per year. Missing just the 25 best trading days over the 28-year period would have resulted in a compound return of just 4.53%, not much better than T-bills.

 

  • Develop an investment plan now: The time to create an investment plan in general, and a well thought-out asset allocation strategy, is now, before any significant market volatility sets in. Asset allocation planning considers both an investor’s willingness to take risk (risk tolerance) and ability to take risk (financial situation). Having this plan in place before the market drops is a key to successful investing.

 

  • Rebalance: Setting an asset allocation and sticking to it is not a passive activity. Systematically buying stocks when they fall and selling when they rise to get back to your targets enforces discipline into the investment plan and applies the information from market prices and valuations to regularly reset your portfolio.

 

  • Consider dollar downside: How much money would you be comfortable losing? When setting asset allocation targets, remember to focus not just on the percentage allocations but also on the amount of dollars at risk. For example, for a million-dollar portfolio, an investor might allocate 60% in equities and 40% in fixed income. But investors need to take another step in the process to fully understand what the experience might be like with that portfolio during a bear market. Suppose we encountered another 2008-type financial crisis, when equities fell roughly 50%, how would an investor in this portfolio experience such a loss? Consider that 60% invested in equities is $600,000. A 50% loss on that amount would total $300,000. Now is the time to decide if you’d be willing to risk $300,000 in losses in exchange for the potential for higher returns.

 

  • Focus on what you can control: We are hard-wired to see patterns where they don’t exist. To overcome that bias, investors must be disciplined and focus on the things they can control while not worrying about what they can’t. We can’t control what the market does, so don’t worry about it. Instead, focus on smart investment decisions like those listed above and you will be a successful investor.

 

[1] Defined as price divided by the average of 10 years of earnings, adjusted for inflation.
[2] A quick reminder that we don’t know what the market return will be.