The S&P 500 had another fantastic year of returns in 2017 and we are approaching nine years of expansion. It is easy to wonder whether this has gone on for too long and if the stock market is becoming a bubble. Using a few different valuation metrics, we can compare where we are currently versus historical averages.
The U.S. economy has reached its 102 month of economic expansion and is rapidly approaching the second longest expansion in U.S. history. The longest was during the 90s and ended in one of the largest valuation bubbles and subsequent crashes. It seems only prudent that we approach the current market with some skepticism as returns have now exceeded 300% since the bottom in 2009.
As we look at current stock prices in comparison to company’s earnings, we can see that we are sitting above historical averages in the chart above by using forward P/E. However, we are still significantly off the highs set back during the 90s and the current market does not exhibit the same bubble-type valuations as then. A large reason that valuations have not become out of control is that companies are still increasing their earnings instead of the wild speculation that we saw during the dot-com bubble.
While the market is expensive relative to history, it is still far away from approaching bubble-type valuations. At Cedarstone, one of the ways we protect against this type of risk is to balance our stock market exposure to companies that are cheaper and less speculative in nature. We want to make sure and seek consistent and reliable returns for our clients over the long term.
Two things to keep in mind. First is that markets can sustain being overvalued for years. Just because the market is above average historical valuations does not mean that we should abandon the markets. 2017 started off in a similar place valuation wise and if one was to get too conservative, they could have missed out on a 20%+ year. Second is that valuations are not a perfect tool to predict bubbles and downturns. In the first chart, you can see that during 2008 markets were not expensive and we still crashed. Remaining vigilant in the later phases of a downturn is the best way to protect a portfolio. Remember your goals and stay disciplined to your investment strategy.