At the risk of being a bit repetitive, I remain very concerned that the U.S. stock market is in a bubble, as with bonds and real estate in many places. Rising interest rates, even if implemented very slowly, may help pop this bubble just as extremely low interest rates for a very long time helped create it. People will borrow less and therefore spend less with higher interest rates, which will slow down economic growth (including home prices) that is already fairly anemic. Also, people will move investments from stocks into cash and bonds as their interest rates rise, creating a drag on the stock market.
On the other hand, the economy is growing, the earnings recession is finally over, and employment is in theory at full capacity, even though that measure is flawed. It is possible that a strengthening economy and a very patient fed can walk the tightrope to gently let the air out of the stock bubble without popping it.
Yet almost all valuation measures indicate that the stock market is in bubble territory and not merely overpriced.
- Warren Buffett’s preferred measure of Market Cap-to-GNP is very close to its all time high.
- The expected returns for a 60/30/10 portfolio of U.S. stocks, bonds and T-bills fell to an all time low, making it the most broadly overvalued moment in market history.
- The Schiller CAPE ratio is well past its 1999 all-time high.
- Financial leverage in stock investments is back to matching other bubble levels and after many years of net outflows from stock investments, we are now, finally, seeing net inflows to stocks, which could be a sign of investors chasing what has done well, and that often occurs before a crash. This is evidenced by households having 42% more exposure to the stock market than usual.
I’ve been concerned with the stock market being overpriced for a few years now, and that concern has only grown as equities continue to rise. And I realize that just because an asset class is overpriced doesn’t mean it will fall in price quickly, if at all. I hope it doesn’t for the sake of many of my clients, but younger investors would be well served by a stock market correction.
My greatest concern is that too many people are over-allocated to the U.S. stock market, chasing what has performed well recently (the S&P 500) and ignoring a proper risk-adjusted diversified portfolio. If you cannot stomach a 50% drop in your U.S. stock holdings, then you are holding too much in U.S. stocks and/or not truly a buy-and-hold investor. Either cut back on your U.S. stock holdings or implement a methodology that would cause you to sell some or all of your U.S. stock holdings after a reasonable decline but before a massive one.
Warren Buffett recently said that about once a decade markets will perform very poorly and that is an opportunity to make significant gains. I believe that we will get such an opportunity within the next couple of years, if not sooner. If not, then the risk/return opportunity of all U.S. asset classes is still too poor to be worth straying from a proper investment allocation. The key is to remember that your performance with an investment is significantly tied to your purchase price, and right now the purchase price for almost all investments is extremely high. This is a time to scale back on your risk, increase your cash, and exercise some patience.