It’s no secret that we and other value-conscious investors have been warning that the stock market is getting increasingly expensive. In fact, the current valuation level of the S&P 500 is at the 96th percentile. This means the market has been relatively more expensive just 4% of the time in its history since 1870.
Furthermore, the S&P 500 would have to decline somewhere between 40% and 60% to revert back to a reasonable valuation average. Unfortunately, these are not timing indicators, and good investors always need to consider the alternative scenario to make sure they are positioned for any outcome. It’s therefore valuable to ask, “How much further could this market run?” and “Am I correctly positioned for this scenario?”
Is a Market Correction Due?
The current bull market in stocks has now eclipsed its eighth anniversary from the lows reached in March of 2009. It is now the second longest-running bull market in history (in terms of days), bested only by the run that lasted from 1987 to 2000.
But as one market saying goes, “Pregnant women are due, library books are due, but market corrections are never due.” Just because a market may be long-running or overvalued, doesn’t mean it cannot run longer or become even more overvalued.
As unlikely as it may seem from this vantage point, the stock market could still have room to run. As a thought experiment, Doug Ramsey of the Leuthold Group noted in a recent interview that the S&P 500 could go all the way up to 3,400 (up over 40% from current levels), if valuations were to revert to the all-time high levels of March of 2000. While not likely, it shows what is possible, based on what has happened before.
In addition, valuing stocks is far from a precise science. There is no one measure of value in the stock market, and each valuation tool has its own caveats. While the price-to-earnings ratio for the S&P 500 is near all-time historical highs, others have noted that our current era of low interest rates and low inflation could be helping to sustain those high valuations. Another factor that could be pulling valuation ratios higher is the collapse in oil prices, and therefore oil profits.
The other alternative scenario is that business and economic conditions could improve, making currently expensive stocks seem more reasonable as their profits and sales increase. Things like tax reform, decreased regulation, or even a breakthrough in technology and productivity could all contribute to higher profit margins.
Personal Investing is Like Golf
But just because all of these things are possible, what is the individual investor supposed to do? Just like golf, the best course to is to avoid expensive errors. I am a terrible golfer, well north of 100 strokes for a round of golf. If I wanted to be a pro golfer, I would have to practice endlessly until I could sink puts from over 20 yards away, and be able to drive the ball over 250 yards every time.
But what if I wanted to be a better amateur golfer? Then the game is not so much about perfection. Instead, to realize a dramatic improvement in my score, the best thing I can do is not make huge mistakes. It is the big errors that get you into the rough, the sand traps, and which cause penalty strokes. It would be far better to hit the ball consistently straight and keep it on the fairway, even it it means it doesn’t go as far, rather than try to “crush it” and end up slicing the ball deep into the woods.
Investing is in many regards the same. We are bombarded with financial media and news that warns us about missing out on the next rally. Our friends and family gloat about “crushing it” with the latest hot stock or asset class, and we constantly compare our portfolio to some magical benchmark that we always fail to beat.
How Long Do You Have?
But investing and trying to preserve your life savings is not a game of golf. The best plan is to try and avoid the big errors: the 40% – 60% declines that can ruin your portfolio for years to come. What does this mean for our current environment? Based on our limited knowledge and current valuation data, it looks likely the stock market will produce low, single-digit annual returns over the next 10 to 12 year period.
There are a couple of ways to approach this reality. The first conservative action to take is to realize and accept that this will in all probability happen. If you or your pension fund needs a 7% annual return over the next decade in order for you to retire, you will fall short, and about the only way to get around this mathematical reality is to push back your retirement age or increase your savings rate.
If you are currently sticking to a buy-and-hold strategy, then you will likely be able to ride it out, but ONLY if you have at the very minimum twenty years (and preferably thirty or more years) to retirement. More time will greatly increase your chances because the market has always gone up over time, but there have been a few 20-year runs that have seen brief periods of low or even slightly negative returns.
The better approach is to stick to a consistent asset allocation plan, with regular (at least annual) rebalancing. Your risk tolerance and the time until you need to use your savings will determine how much you allocate to stocks.
For example, we have reviewed the Permanent Portfolio in the past, which allocates one-quarter of a portfolio each to stocks, bonds, cash and precious metals. The smaller stock portion will keep you invested and allow some exposure to a market rally that may indeed continue, while the allocation to cash and gold will dramatically reduce your risk without sacrificing too much return.
An Under-Appreciated Asset Class
Finally, investors looking for an asset class that has not yet ballooned to all-time highs should seriously consider gold and silver. Both are below their all-time highs. Gold could go up over 50% before it reaches its all-time high, while silver could soar over 230%! This is in addition to the fact that precious metals stabilize portfolios because they tend to be negatively correlated to stocks.
Investing is not a game, and your portfolio performance is your own personal scorecard, something you work on to meet your life goals, not to try to beat others or benchmarks. In a world of extreme monetary policies and overvalued stock markets, a precious metals ‘balancing’ strategy is the golf equivalent of laying up in front of the pond, rather than trying to reach the green in one stroke and risking a very costly penalty.