The Case of the Expensive Market

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It’s a real mystery.  The market is expensive, yet stocks have nevertheless been trending ever higher.

Bloomberg News reports that in a recent closed-door investment confab, the legendary hedge fund manager Paul Tudor Jones observed that the total market capitalization of U.S. stocks is currently about 125% of U.S. GDP.  In other words, the aggregate value of American equities (which represents the economic output of only a fraction of the economy) exceeds the goods produced and services provided across the entire U.S. economy.

For perspective, before the financial crisis this number reached 110% and before the dot com bubble burst in March of 2000 this figure hit 151%.  A measure of 125%, therefore, is expensive (the long-term average is 68%), but not unheard of.

Furthermore, the cyclically adjusted price-to-earnings (P/E) ratio (a measure of the index’s price divided by its ten-year average inflation-adjusted earnings; also known as the Shiller P/E) of the Standard and Poor’s 500 is more than 29 times.

This ratio has only been around these levels in two prior periods – 1929, just before the Great Depression and from 1997 until 2000, a period of market gains that ended with the S&P 500’s bear market from March of 2000 to November of 2002.

The Shiller P/E was just over 44 at its December 1999 dot com peak.  So, again, at 29 times, stocks are expensive (the long-term mean is 16.75), but not as expensive as the dot com days.

Such rich valuations are no guarantee that the market will fall imminently.

A recent Yale University survey of professional money managers found that 99% of us believe that the Dow Jones Industrial Average will be higher one year from now.  However, over half of those same managers say the market is expensive.

This disconnect is a bit disturbing because financial markets always revert to the mean eventually.

Said differently, if stocks are now expensive, at some point the pendulum will swing and equities will be cheap again.  If managers see the market as too expensive but also anticipate further gains, they are counting on a major pick-up in corporate earnings and, therefore, economic growth.  But, what happens if news disappoints, do stocks then disappoint?  Herein lies the mystery.

Because timing the market is impossible, we can’t solve the mystery of the ever-ascending market.  Rather, we must enjoy it, manage it and prepare for a day when things aren’t so simple.  Here’s how we are proceeding:

Enjoy it while we can . . . Valuations are a poor market timing tool.  Stocks can stay expensive for a long time.  Momentum is a powerful force in investing.  In the final leg of a bull market, investors will look for any reason to keep the rally going.

Keeping an appropriate allocation to stocks, even when we know equities are expensive, is necessary so that we can participate in rallies like the current one.  No expert or pundit knows when the market will stall.  Hence, we’ll never make an all-or-nothing bet for or against stocks.  Otherwise, there is the possibility of missing strong periods.

Rebalance allocations and reevaluate goals . . . Very simply, rebalancing means bringing your allocation back to your long-term target.  If your target is 60% stocks and 40% bonds and, given the outperformance in stocks, you now have 70% in stocks, then rebalancing back to 60% stocks is prudent.  We’ve been actively doing this for clients.

Additionally, because the market has been robust for a long time, many of our clients don’t need to be as aggressively invested to meet their goals (they actually have a higher probability of meeting their retirement spending needs with a lower stock allocation).  Specifically, for some clients, it is more optimal in our retirement income projections to have more exposure to bonds (a lower volatility portfolio) to more consistently fund retirement outlays.

Seek shelter gradually . . . Due to the impossibility of timing the market, implementing subtle changes may involve selling aggressive, expensive holdings and trying to replace them with more defensive-oriented stocks.

For example, we recently sold our position in Coach, the fashion brand, and we have been gradually adding a position in CVS Health, the pharmacy benefit and retail behemoth.  Still more subtle is our normal discipline of rebalancing within our equity portfolio, which dictates that we add to underperforming and out-of-favor names that will ultimately rotate back into the market’s good graces as circumstances evolve.

Bottom line, it is best not to “fight the tape.”  We will happily participate in the present rally.  But, we will do it with our eyes open.

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