“… be fearful when others are greedy and greedy only when others are fearful."
Berkshire Hathaway annual letter, 2004
Negative surprises like we’ve seen this past week are always concerning. Even more so when the stock market is expensive. Today it is very expensive. That does not necessarily mean that it will go down tomorrow. What it does mean is that stocks are likely to do less well in the decade ahead.
The price-to-earnings ratio of stocks is now 30x, double its historic average of 15x. This means that stocks are today priced near the same level as the 1929 market peak, just before the Great Depression. Since then, there’s only been one other time that the market’s value has been higher: 1999, the height of the internet bubble.*
The problem is that too many investors (and their advisers) assume that the stock market’s high past average returns (of ~10% per year) will continue into the future. This ignores today’s higher price paid.
The price you pay for an investment up front is one of the primary determinants of your ultimate return on that investment. It’s no different than shopping for antiques. If you find a bargain, you can make a great return on the purchase of a not-so-great chair. Conversely, if you overpay for an item – even for a vintage Baccarat vase – your return will be poor, perhaps even negative.
Meb Faber wrote a great report emphasizing this point.** If you look at the 10 best decades of stock market returns, the average price/earnings of the S&P 500 at the beginning of the period was 10x. If you then look at the 10 worst decades of stock returns, the average price/earnings at the beginning of the period was 23x. (Remember, it’s 30x today.)
What, then, should we do? Avoid stocks? No. Stocks are still one of the best ways to preserve the value of your assets over time against inflation. In an earlier note, I’ve emphasized that the longer your holding period, the less important price paid becomes. If your time-horizon is well over a decade, and if you do not plan to draw on your portfolio for income for a long time, then you’re likely fine with a very heavy allocation to stocks. (Our man Warren Buffett recommends such.)
Yet if you have a shorter term horizon or need to draw income from your portfolio, today’s high valuations suggest you need a lower-than-typical allocation to stocks. How much is that? Everyone’s circumstances are different, and thus, the answer to “how much in stocks?” varies person to person.
We are happy to help you calculate the optimal allocation to stocks given your own circumstances and in light of today’s high stock valuations.
Yours in the Field,
Frank Byrd, CFA
* As measured by the cyclically adjusted price/earnings ratio of the S&P 500 (according to research by Robert Shiller, Yale University). As an aside, I’d point out that the S&P 500’s price/sales ratio is today even higher than 1999’s level.
**Mebane Faber, “Global Value: Building Trading Models with the 10-Year CAPE”, Cambria Quantitative Research, Issue 5, August 2012.
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