Love and Death In A Time Of Elevated Shiller P/E Ratios
What’s an investor to do?
In his recent New York Times article “Caution Signals Are Blinking for the Trump Bull Market” (link here), Nobel Prize-winning economist Robert Shiller argues that the market is expensive based on his own cyclically adjusted price-to-earnings ratio that compares the value of the current market to inflation-adjusted earnings of the past ten years.
That overall market valuations have indeed been increasing should come as no surprise to readers of my March 15th post, in which I talked about the risk to stock prices in the event the market were to revert to its five-year median valuation.
This increase in valuations over the last decade has been driven, in part, by the flood of assets into passive funds. More recently, valuations of cyclical shares have expanded based on the hope that President Trump will be able to reinvigorate both the U.S. and global economies.
Given this trend, there are three responses an investor can consider:
1. Raise Cash
Raising cash due to higher than typical valuations seems like a savvy approach, but is a tricky business at best. Since over the long-term, cash is not a good investment, it means that one will have to not only pick the right time to pull out of the market, but also the right time to re-enter.
Throughout my twenty seven years on Wall Street I have never met anyone who caught the bottom of a bear market or timed the peak of a bull market -- let alone done so on a consistent basis. Rather, I have met far too many investors who cashed out of the market and, paralyzed by the fear of getting back in at the wrong time, sat on cash for years and thereby lost substantial purchasing power after inflation.
2. Allocate More to Fixed Income
While allocating a higher percentage of overall assets to fixed income might seem prudent and conservative, with the Ten-year Treasury currently yielding 2.5%, fixed income may help cushion against market volatility, but over the next decade it is still unlikely to beat inflation.
3. Remain Invested But Avoid Stocks with Expensive Valuations
I believe that remaining invested but avoiding stocks with high valuations is the solution most likely to generate positive real returns over the next decade. Even in markets that have high Shiller P/E ratios, there will always be stocks that have lower than average valuations. There may be individual companies that are under a cloud for any number of possibly transient reasons, like disappointing quarterly sales or delayed regulatory filings. Or there might be whole out-of-favor sectors, much the way the “old economy” industrial stocks were despised at the height of the dot.com boom.
As you may remember, those beleaguered “old economy” stocks turned out to be great investments once the market regained its sanity and profits reverted to being more valuable than page views.
2017 has already been a quite surprising year. What the future may hold we don’t profess to know. But rest assured that we will be doing what we have always done – seeking the best investments we can find while doing our best to mitigate downside risk.
Integre Asset Management Disclaimer – 4/5/2017
Past performance may not be indicative of future results and every investment program has the potential for loss as well as profits. This material is presented solely for informational purposes and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security or fund interest or any financial instrument. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information. All information is current as of the date of this material and is subject to change without notice. The views expressed in this presentation are subject to change based on market and other conditions. Any views or opinions expressed may not reflect those of the firm as a whole. Additional information can be provided upon request.
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