Stock valuations are high by historical standards. At the start of every year, experts come out in force to predict the direction of the stock market in the coming year. For most investors, the best strategy is to have an investment strategy that matches your personal situation and stick with it. This is easier said than done.
Many experts have said they think the market is overvalued. Caution flags have been raised by multiple people who have wide following:
The “Buffett Indicator,” named after the famous investor, is nearing its all-time high. This indicator is the total market capitalization divided by GDP. This is currently around 190%. A market at “fair value” would be around 100%.
Steve Forbes, writing in Forbes Magazine, cited the same indicator. He commented that stocks have not been this high since 2000, just before the dot-com crash, and mentioned the increase of Initial Public Offerings (IPOs) and Special Purpose Acquisition Companies (SPACs). Other factors mentioned are anticipated increased regulation, and pandemic effects. He recommends continuing making regular investments, not selling stocks you are holding for the long term and building up cash reserves. Additionally, he recommends holding gold, either physically, or as part of a gold ETF (such as GLD), as a hedge against inflation. The only offsetting factor to his bearish view is that there is still a lot of cash on the sidelines.
iJeffrey Gundlach, founder of Double Line Capital and a famous billionaire investor, says he is concerned the dollar may be headed for a significant downturn in 2021 and 2022. US Equities have significantly (and unreasonably) outperformed international equities over the past five years. But despite this growth in the US stock market, US GDP has not kept pace with other countries’ GDPs. Moreover, the S&P 500 growth has been concentrated in just six companies, there has been a retail trading frenzy (driven by various pandemic factors), there is an ever-increasing debt overhang in the US. Gundlach’s perspective is that most US stocks are not doing very well, making the gains somewhat illusory.
Does this mean the market will decline? Nobody can predict what will happen in the short term.
The famous investor, Benjamin Graham, one of the authors of a 1934 fundamental investing book, Securities Analysis, had this to say about the stock market: In the short term, the markets are like a “voting machine,” measuring the popularity of a stock, or of stocks as a whole; but in the long-term, they are like a “weighing machine,” in that companies who produce the most value (earnings) tend to outperform.
The market can stay irrational longer than you can stay solvent. If stock momentum is up, there is a good chance stocks will continue to advance, until they do not anymore. Let other people take the risk of selling too early.
What else might happen?
The market does not have to collapse just because PE ratios are high. Historically, markets have entered consolidation phases. Sometimes these last for years, while net earnings increase, bringing PE ratios back into a more normal range. Market segments do not move in lockstep. Some segments, such as international or small cap, will be out of favor for years, then suddenly, will rotate back into favor.
The stock market is priced on anticipated earnings. If there are positive earnings surprises, price-to-earnings multiples could decline, even while stocks continue to appreciate.
Should I get out of the market altogether?
As mentioned, let others be the ones to sell early and miss the opportunity to capture momentum. It is said that people have lost more money in opportunity costs by anticipating bear markets, than in the actual declines they are afraid of. I am not sure whether I completely agree with this sentiment, but there is merit to it, nonetheless.
If the daily swings in your portfolio value are really keeping you up at night, that is probably a sign that you do have too much at risk in the market. If you are worried about losing money you cannot afford to lose, that is another sign.
What is the Fed’s role in this? Governments are busy with their experiment in Modern Monetary Theory. Payments to prop up the system have been going on in many ways, for decades. These have accelerated in the past 12 months. The US Federal Reserve is printing money as fast as they can.
If, as the laws of economics suggest, governments and central banks overdo things and kick off inflation, investors will be glad they held on. With interest rates at all-time lows, most real yields are negative, when even today’s present modest inflation rate is considered.
Despite high valuations, stocks will probably have greater returns than bonds in the next 10 to 20 years, regardless of how they perform in 2021. If you are still accumulating assets, keep saving on a regular basis. Money that you can keep invested that long should still be in stocks.
If you have multiple investing goals that need to be balanced, such as paying off student loans, planning for education, college, saving for a first home, retirement, you may need to work with a financial planner to help you sort it all out. Another area where professionals can help is determining how to build or spend down a portfolio in the most tax-favored ways. With laws changing constantly, it is hard to do it all by yourself.
Practical actions
- Make sure you have enough reserves to weather a downturn. Holding money in a bond ETF is not the same as having a reserve. Same for your company stock. Insured deposits at a bank or credit union, or obligations of the US Treasury, are the most secure investments.
- Know how much risk you can take. This is where a financial adviser can help.
- Do not be afraid to part with stocks that have gained a lot but know which ones to sell.
- Do not let the tax implications of a sale cause you to postpone. The only thing worse than having to pay taxes, is NOT having to pay taxes!
- Rebalance while the market is still high if you need to. If you determine that your overall risk is too high, do not delay.
- Further reading:
The information above is for educational purposes only. Nothing presented in this article should be construed as investment advice.
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