Stock and Bond Market Valuation

| July 27, 2021

Several clients have recently asked about an impending major market correction and whether we should make their portfolio significantly more conservative. Markets move quickly in both directions, but generally move down more quickly than they move up. When news of a global pandemic started to become a reality, the S&P 500 price index fell 34% between February 19, 2020, and March 23, 2020. The S&P 500 price level increased 92% over the next 15 months ending June 30, 2021. Fear, uncertainty, and doubt were a constant as news headlines about COVID, a second wave, social upheaval, protests, and a contentious election permeated everyone’s awareness. In fact, in our blog piece featured in October 2020 we discussed the ironic nature of human uncertainty and market growth. Given we are at record all-time highs, with an effective vaccine (so far) and a dramatic global reopening underway, we wanted to share our thoughts on the market’s valuation and allocation of investments more broadly as we look forward.

Investors look at valuation metrics like the price per unit of earnings, sales, or cash-flow to gauge how expensive the market is. One of the most recognized valuation metrics is price to earnings or P/E. The lower the P/E, the less expensive the market; the higher the P/E, the more expensive the market. The S&P 500 currently trades at 21.5 times the next 12 month’s earnings, well above the 25-year average of 16.71. There were various economic backdrops across that 25-year span which contributed to the P/E average, some of which were starkly different from today.  Interest rates today at less than 0% after factoring in inflation create a world not easily comparable to the world between 1990 and 2000, or even up to the 2008 Great Financial Crisis. One of the arguments for continued allocation to equities is ‘there is no alterative’ (or ‘TINA’ for short). Even if one concludes that the stock market is overvalued, the bond market looks even more expensive. The 10-year treasury yield as of me typing on July 26, 2021 is 1.29%. Translated into an equivalent P/E, the 10-year treasury yield is trading at a price level of 77.5 times next years ‘earnings.’ If you look at global bond yields, Germany, France., Japan and the U.K. all have negative yields. The only major economies with 10-year bond yields higher than the U.S. are China and India. This ultra-low interest rate forces us to consider the valuation of stocks relative to other options available.  

For argument’s sake, perhaps the market gets to a valuation level where one decides to sell stocks. Decreasing stock exposure is prudent at times and is part of a sound risk management approach. Rebalancing your portfolio back to a target asset allocation can enforce good discipline and lower volatility from lower stock exposure. Problems can emerge when investors decrease or eliminate stock exposure because of generalized fear of a large market sell-off (20% or greater), and without a re-entry plan (you need to be right twice, and many times people ‘anchor’ to a specific price level).

If we take 2020 as an example, unless an investor were to reinvest back into the market during the teeth of COVID panic, the market was at back at pre-covid levels only 4 months after hitting lows. If you had invested back into the market on July 21, 2020 when the NIH said, ‘early results from...showed that it triggered an immune response against the virus…” the S&P 500 had already recovered all its losses. Warren Buffet famously stated ‘…there’s a fog of panic too, and during that panic, you’re getting inaccurate information, you’re hearing rumors, if you wait until you know everything, it’s too late.’ This was the case during the COVID bear market, and the 2008 financial meltdown. In fairness, the person who sold on February 19, 2020, slept better at night than the one who didn’t, but after several months, they are in an economically equivalent position.

When making investment decisions, looking at scenarios based on probabilities can provide perspective. For example, there is always a possibility that after you sell, stocks continue higher over the next 12 months. In fact, according to UBS , historically, stocks have performed slightly better than average after hitting all-time highs, based on data going back to the 1960s. There are also scenarios that can play out that are better than a worst-case scenario. The reality is that over a multi-year time frame, selling stocks because you think the market is overvalued has proved to be a losing strategy more times than not. While this time could be different, odds are it is not. How much of your retirement nest egg do you want to bet on a low probability scenario? If you feel the need to do something, consider rebalancing your portfolio, or reallocating to less expensive areas of the stock market based on traditional valuation metrics. Above all, understand that an appropriate asset allocation strategy is an important tool in achieving your long-term financial planning goals. Simply making sure your allocation aligns with your goals can help eliminate many errors (timing the market) that are difficult to recover from.