The U.S. Stock Market is Expensive ... and What You Can Do About It
In the last installment of Articles on Wealth Management Topics, I mentioned that "... our stock market [is] becoming expensive, and by some measures very expensive," and then discussed various yardsticks we can use to gauge the relative value of an overall stock market. Using these yardsticks, we can then, for example, compare our U.S. stock market to other stock markets around the developed world to gain some insight into how much to invest domestically vs. internationally.
On that note, here is a chart comparing the CAPE ratio of a couple of dozen developed stock markets around the world. The CAPE, or Cyclically Adjusted Price Earnings, ratio is a valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle.
Obviously the decision on whether or not to invest internationally, and if so to what degree, must rest on more considerations than just stock market valuation. Currency risk, the geopolitical backdrop, and economic outlooks both here and abroad all have a role to play in this asset allocation decision. But this chart illustrates one of the reasons why I'm inclined to believe that the U.S. stock market as a whole is relatively expensive.
Closer to home, and perhaps closer to your heart, current measures of stock market valuation should play a pivotal role in planning for retirement, college funding projections, and budgeting for major purchases in the future. Future portfolio returns may make or break your ability to achieve these financial objectives, and in turn, future portfolio returns are driven by current stock market valuations. This has been an ongoing theme in this blog.
But a picture is worth a thousand words, so here is an insightful graph showing the strong inverse relationship between the valuation of the S&P 500 at various points in time in the past and subsequent 10-year returns. The conclusion we should draw from this graph is that, if history is any guide, when the U.S. stock market is expensive (as it is now by almost any metric), we should expect lower-than-average returns going forward.
This of course has tremendous implications for retirement planning since retirement projections hinge on realistic assumptions about the returns that our nest eggs will generate in future decades. And if a recent Natixis (a global asset management company) survey is anything to go by, retirees in this country are in for a rude awakening.
In its 2023 Global Survey of Individual Investors, on average the U.S.-based investors surveyed said they expect our stock market to generate returns of 15.6% above and beyond the rate of inflation per year over the long run. Not only is this return more than twice what the S&P 500 has managed to generate over the last century, but this expectation totally ignores the stock market's current lofty valuation. By contrast, you can see from the graph mentioned above, and more specifically the yellow diamond data point highlighted in the middle of it, that future U.S. stock market returns are more likely to be in the neighborhood of mid-single-digit percentages.
Other eye-opening findings from the Natixis survey of individual investors?
- "61% wrongly assume that index funds are less risky than other investments, and nearly two-thirds (66%) think index funds will help them minimize losses – something they just can’t do";
- "The survey included a quiz on bonds and [interest] rates designed to gauge how many investors truly understand what a rising rate environment means for bonds. Only 2% of investors, or 171 out of 8,550 individuals in 23 countries, [and only 3% of U.S.-based investors] could provide the correct answers: present value goes down and future income potential goes up"; and
- "More than two-thirds (68%) say that recent inflation has highlighted the importance of professional advice".
What You Can Do When the U.S. Stock Market is Expensive
When the U.S. stock market is expensive, diversifying your portfolio away from that asset class becomes even more important, either to reduce risk and/or to supplement future returns. Here are some possible moves to consider:
Rebalance to Bonds
In November I was quoted in Financial Planning magazine as saying that the dramatic increase in interest rates we've experienced in the past couple of years represents a "return to normalcy" in the bond market rather than a buying opportunity not to be missed.
However, as I also said there, "... bonds belong in any balanced portfolio". Given that it's fairly easy now to find close-to-riskless bond exposure that yields more than 5% and given the fairly lackluster outlook for U.S. stock market returns, it may make sense to re-allocate at least some of your nest egg from the latter to the former. One simple way to do this is to rebalance your portfolio back to its target asset allocation, as I explain in this ThinkAdvisor article, 10 Keys to Boosting Retirement Portfolios in a Surging Market: Advisors’ Advice.
Use Buy-Write Funds for Stock Market Exposure
When the stock market is expensive, the odds of a correction or of an outright bear market increase. So-called "buy-write" mutual funds provide a measure of downside protection to counter this risk, and they simultaneously boost current income in comparison to plain-vanilla equity mutual funds. Of course, trade-offs are always necessary when investing, and the price you pay for these attractive attributes is to sacrifice some participation in the stock market's upside, but this is less of a concern when the market is already expensive and its upside potential more limited.
The investing public certainly seems to be catching on to the merits of buy-write funds, judging from the massive inflows that the JPMorgan Equity Premium Income ETF and its competitors are attracting. I, however, have preferred to gain access to the buy-write strategy via closed-end funds. CEF's that write call options against their portfolios of dividend-paying stocks were a bit cheaper in comparison to their net asset values during tax-loss harvesting season last fall, as I explained at the time in this CNBC article, but there are still compelling bargains to be had.
Introduce Inflation Hedges Into Your Portfolio
Given the Natixis survey's finding that inflation has become a primary concern for investors and one that we haven't had to contend with for decades, it's worth revisiting the topic of Investing and Debt Management in an Inflationary Environment for ideas along these lines. And while we're on the topic of inflation, retirement projections can be stress-tested, both for higher inflation and/or for lower U.S. stock market returns going forward, as I discuss in this Bankrate article on How a financial advisor can help you fight inflation.
About the Author
Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.