Is the stock market expensive? Yes and No
After 6 years of a bull market, many are calling for a stock market top. Others say there is room to run. Which is it? Is the stock market expensive or isn’t it? Unfortunately, the answer is “Yes” and “No.” Here is what I mean.
One of the best predictors of stock market returns is the Cyclically Adjusted Price Earnings Ratio or Shiller PE Ratio. The Ratio, developed in the 90's by Robert Shiller out of Yale University, adjusts for cyclicality in the earnings of companies by using 10-year average earnings. It compares these average earnings to current prices to answer the age-old question, “Are stocks cheap or expensive?”
The answer based on today’s reading of Shiller’s PE is “Yes” and “No”. While today’s reading of 27 is high compared to history, this reading is often followed by some of the highest and lowest returns in the stock market. See the chart below.
While this seems like it isn’t really an answer, there are a few important implications for the future. First, we expect more volatility this year, especially as the Federal Reserve begins to raise interest rates. Secondly, we would generally not want to add additional stock risk, despite (and really because of) the strong performance that stocks have provided over the last few years. Lastly, we still believe it is appropriate to stay invested in stocks. Despite the volatility ahead, the risk of being out of the market if stocks continue to rally is simply too great. As Peter Lynch, the legendary investor of the Fidelity Magellan fund said, "Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves."
Ultimately, the right answer is to stay appropriately diversified and focused on your goals, rather than the latest news. While it is tempting to try to time the next correction, the truth is that even the best predictive indicators are imperfect. By finding the right portfolio, we don’t have to be worried about the next correction but rather can take advantage of it when it happens.
If you are worried about today’s market and would like to learn more about our investment philosophy, or would like a free portfolio review, please give us a call.