Enjoy It While We Can
Published On: September 3, 2021
Written by: Ben Atwater and Matt Malick
The market is expensive, yet stocks have nevertheless been trending ever higher . . . for many years!
Back in April of 2017, Bloomberg News reported that at a closed-door investment confab, the legendary hedge fund manager Paul Tudor Jones warned of excessive stock market valuation when he observed that the total market capitalization of U.S. stocks was 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) exceeded the goods produced and services provided across the entire U.S. economy.
Fast forward, however, and this number, “market cap to GDP,” now stands at 204%. Tudor Jones’ warning was premature.
For perspective, before the financial crisis in 2008 market cap to GDP reached 110% and before the dot com bubble burst in March of 2000 this figure hit 151%.
A measure of 125% back in 2017, therefore, was expensive and Tudor Jones was right to note it (the long-term average is 87%), but not unheard of. Today’s measure is off the charts, so to speak.
Furthermore, back when Paul Tudor Jones spoke in April of 2017, 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 was more than 29 times.
This ratio has only been around these levels in two prior periods – 1929, just before the Great Depression, when the number stood at about 30 times, and from 1997 until 2000, a period of market gains that ended with the S&P 500’s peak in March of 2000.
The Shiller P/E was just over 44 at its December 1999 dot com peak. So, again, at 29 times, in April 2017, stocks were expensive (the long-term mean is 16.84), but not as expensive as the dot com days. Today, this P/E measure stands at over 39, somewhere between the 1929 and 2000 tops.
Such rich valuations are no guarantee that the market will fall imminently. After all, as Tudor Jones observed in 2017, valuations were quite rich, but despite a short-lived bear market in 2020, markets have performed quite well over this period.
These measures go to further demonstrate that timing the market based on valuations is an impossible task. What is expensive or cheap, can get more expensive or cheaper – it is impossible to predict.
Therefore, we cannot simply react to overvaluations and condemn the ever-ascending market. If we would have bailed from the market in 2017 when many measures showed it to be too expensive, we would have missed a lot of returns.
Rather, we must enjoy it, manage it and prepare for a day when things are not 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 bull markets. No expert or pundit knows when the market will stall. Hence, we will 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. To manage capital gains, our rebalancing usually involves a gradual process of tapping equities as a source of funds for distributions, while reinvesting interest and dividends into bonds.
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 have a higher probability of meeting their retirement spending needs with a lower stock allocation).
Specifically, for some clients, it is optimal in our retirement income projections to have more exposure to bonds (a lower volatility portfolio) to fund retirement outlays more consistently. In tax-deferred accounts, like IRAs, we can rebalance more dramatically without incurring capital gains.
Seek shelter gradually . . . Due to the impossibility of timing the market, implementing subtle changes may involve rebalancing into more out-of-favor stocks in the market.
For example, our normal discipline of rebalancing within our equity portfolio dictates that we add to underperforming names in anticipation that they should ultimately rotate back into the market’s good graces as circumstances evolve. We often do this when aggressive portfolios accumulate cash from dividends or clients add funds to their relationship.
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, always mentally preparing for less robust times.