It’s been a little while since one of my commentaries because I’ve been very busy preparing (and updating) financial plans for clients old and new.
I have some long-time clients that are coming up on their retirement dates so we’ve been updating the projections accordingly and making necessary adjustments.
Additionally, about five new families have reached out within the last couple months so I’ve been busy preparing their financial plans as well. The financial plans serve as the blueprint for all major financial decisions we make together so it’s a critical, necessary first step in my relationships. It’s been a very busy but fun and very rewarding couple months!
Today, I wanted to provide an update on stock valuations to ensure we’re being mindful of the big picture and not getting too caught up in the short-term noise.
BUT, FIRST, LET US REMEMBER: Investing is a means to an end not an end in and of itself. For most people, investing is a means to an enjoyable, comfortable, stress-free retirement and maintaining their lifestyle throughout retirement. For some others, investing is also a means to gift more money to charity and family. However, for too many people as of late, “investing” has become a hobby, an obsession, a get-rich-quick scheme and/or a source of entertainment. “Investing” has simply become another method of gambling without regard to how various “investment” decisions can impact investors’ most important, long-term financial goals. That gambling mentality is another common feature of bubbles throughout history by the way.
So, let us always remember the true purpose for investing and keep that big picture in mind when making investment decisions. Let us always remember our “why.”
When looking at valuations it’s important we only spend time on those metrics that have the highest correlations to subsequent returns, otherwise what’s the point? Everything else is just noise. For example, P/E ratios and Forward P/Es, the most oft-quoted valuation metrics in the financial press, have relatively low correlations to subsequent returns so they’re not very useful.
The best valuation measures are those that reflect price of a stock (or index) relative to a reliable estimate for a very long-term stream of cash flows. After all, when you buy ownership in a company (i.e. stock) you are buying a very long-term stream of cash flows. Some estimates of cash flows are better than others, which is why some valuation metrics are reliable and others are not.
Here is an extremely reliable valuation metric from one of world’s leading authorities on the subject (Dr. John Hussman). This has an extremely high correlation (over -90%) to subsequent twelve-year returns as illustrated clearly in the chart below:
On the y-axis are actual historical annual returns for the S&P 500 (going back to 1928) while the x-axis contains the valuation metric. We immediately notice a clear relationship between valuations and subsequent returns. The higher the valuation at the starting point of the period the lower the return over the subsequent twelve years and vice versa. As I’ve written about before, “The Price You Pay Determines Your Return!”
In the chart we see this particular valuation ratio at 3.34x, which is the highest its ever been in history. This implies lower forward 12-year returns than ever before in history as well. And, no, low interest rates do not change this.
Historically, over very long periods of time, the S&P 500 has delivered about 10% annually. In the chart we notice that in order to achieve future returns on par with historical averages, we’d need to see this valuation metric very roughly around 1.00 (between 0.7 and 1.5), which is obviously far lower than the current ratio of 3.34x.
The current valuation of the S&P 500 implies an estimated 5% annualized LOSS in the S&P 500 over the next twelve years. That amounts to a 40% cumulative loss over twelve years (including dividends)!
Now, that doesn’t mean the S&P 500 will lose 5% every year for twelve years but more likely would result from a really bad couple years within the period that wipes out many years of past gains.
To break it down even more simply: This appears to be the worst time in history to be OVER-weight U.S. stocks.
Let me be clear, I’m not suggesting we need to embalm our assets in cash or avoid U.S. stocks altogether as it’s impossible to know exactly how this all plays out and when. However, I am warning people to avoid the temptation to chase U.S. stocks higher, to avoid OVER-weighting their portfolios to U.S. stocks (particularly low-quality speculative assets with no earnings and cash flows barely sufficient to service debt), and to remind investors to stress-test their retirement plans against a severe bear market before making critical retirement and investment strategy decisions. If your advisor isn’t doing this, or you manage your own finances and don’t have the tools to perform this analysis, and you’re nearing retirement (or recently retired) absolutely reach out to me to help. This is a critically important exercise.
Additionally, another takeaway from all this is it makes sense to incorporate other asset classes in portfolios instead of being so narrowly focused on U.S. stocks.
Risk management MUST be a priority for investors today…especially those who are nearing retirement or recently retired because having too much stock exposure at the outset of a severe bear market can jeopardize everything they’ve worked, saved and sacrificed for throughout their career. They no longer have time to make up those losses as they once did.
Extreme asset valuations combined with extreme debt only make those assets more fragile and more susceptible to severe downturns. Of course, no outcome is guaranteed and timing is impossible, but the probabilities are far out of U.S. stocks’ favor.
All the other reliable valuation metrics are flashing the same warning signal as the one shared above so this is not cherry-picked. I’ve spoken about other metrics at length in previous commentaries. If you want a more detailed review please watch my video from March.
Article Title: YOLO = You Only Live Once, FOMO = Fear Of Missing Out, HODL = Hold On For Dear Life
Past performance is no guarantee of future results. All investments maintain risk of loss in addition to gain.
Data from third-parties is believed to be reliable but accuracy is not guaranteed. Much of the data used to interpret the markets and forecast returns are often at odds with each other and can result in different conclusions. Many different factors impact prices including factors not mentioned here.
This is NOT investment advice but merely a general commentary. Individualized investment advice cannot be provided until a thorough review of your unique circumstances and financial goals is completed.
Views provided here are current only as of the moment of posting and are subject to change at any time without notification.