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High Stock Market

How High is Too High for the Stock Market?

High Stock Market

Stocks have rallied a lot from the lows they hit in early 2009.  Stock market gains have come from a combination of confidence in the global economy and robust earnings growth for corporations.  After another year of sizable stock market gains in 2017 investors are right to ask: How high is too high for the Stock Market?
Let’s face it, investors are asking this question because folk wisdom teaches us that what goes up must come down.  Does this kind of folk wisdom apply to stock market returns, though?

Studying Stock Market Returns

To explore this question, we studied stock market returns in the post-war era.  Starting in 1945 and through the present day we sorted returns for the S&P 500 into groups based on the starting valuation.  We define valuation as the Price to Earnings Ratio, which compares stock prices to the underlying profits of the companies investors are buying.  A P/E ratio of 10, for example, indicates that investors have to pay $10 to buy shares today for every $1 of profits produced.
After a long rally, the market today is in fact expensive by our measures.  The P/E ratio is about 22 as of the end of 2017.  What we found is that higher valuations are not good predictors of losses, but they are good predictors of lower, but still positive, average returns.  The chart below organizes the data into groups based on periods (1, 3 and 10 years) and starting valuations (cheap, average, and expensive).

 

This chart has several important points.  The first is that  in the short term anything can happen to the stock market.   Over one and three year time periods, the markets can deliver low returns and even big losses regardless of valuations.  This shows why trying to time the market is not effective. It also shows what range of returns investors might expect.  The second is that valuations do in fact affect returns on average.  Based on the P/E ratio of 22, US stocks are in the range of valuations that has delivered a 7% return on average for investors since 1945.  That’s markedly lower than the historical average of about 10% for all valuations.

How to Respond

How should investors respond to this?  We recommend a three-part approach:
  1. Diversify globally.  U.S. stocks have rallied more than stocks abroad since 2009 and have some of the highest valuations.  Bargains are available to investors in developed foreign markets (such as Western Europe and Japan) where valuations are close to historical norms.  Emerging Markets (such as China and Brazil) offer valuations below historical norms and higher potential returns.
  2. Gauge your risk tolerance.  After nine years without a bear market, investors may treat the chance of stock price declines as a hypothetical risk.  It is not.  Investors should take a look at the chart above. Particularly for the 1 and 3 year periods imagine how they would feel about their portfolios if the returns were on the low end of those bars and investors are facing losses.  Now is the best time to make sure our eyes aren’t bigger than our risk appetite.
  3. Construct your financial plans with lower returns in mind.   When we run financial plans for our clients, they reflect lower expected returns today than they did at the bottom of the market in 2009.  This will help to avoid surprises if market returns fall below their long term averages.

Important Disclosure Information

The index returns shown above show the total return for various investment indices and include the impact of the reinvestment of dividends. A comparison to indices may not be a meaningful comparison. Comparisons to benchmarks have limitations because benchmarks have volatility and other material characteristics that may differ from the performance of a client’s portfolio. The investments in a client’s portfolio may differ substantially from the securities that comprise each index and are not intended to track the returns of any index. One cannot invest directly in an index, nor is any index representative of any client’s portfolio.  Actual client accounts will hold different securities than the ones included in each index. The index returns are gross of applicable account transaction, custodial, and investment management fees. The actual investment results would be reduced by such fees and any other expenses incurred as an investor.  Please see below for definitions of the indexes used.
The S&P 500 is an index consisting of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be an indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large-cap universe. Each constituent in an index is weighted by its market-capitalization, as determined by multiplying its price by the number of shares outstanding after float adjustment.

Important disclosure information

Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by RegentAtlantic Capital, LLC (“RegentAtlantic”) will be profitable.

Please remember to contact RegentAtlantic if there are any changes in your personal or financial situation or investment objectives for the purpose of reviewing our previous recommendations and services, or if you wish to impose, add, or modify any reasonable restrictions to our investment management services. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.

This article is not a substitute for personalized advice from RegentAtlantic. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed in other businesses and activities of RegentAtlantic. Descriptions of RegentAtlantic’s process and strategies are based on general practice and we may make exceptions in specific cases.

RegentAtlantic does not provide legal or tax advice. Please consult with a legal and or tax professional of your choosing prior to implementing any of the strategies discussed in this article.

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