As I shared in last week’s post, the current stock market valuations, especially tech stocks, are priced at elevated valuations from a historical perspective. Additionally, the economy is weakening by a variety of measures. Inflation is still lingering higher than what the Fed is targeting and many economists fear that the impact of tariffs have yet to be reflected in the data. The U.S. fiscal deficits and national debt show no signs of improvement, and worldwide concern over them seem to be increasing.
Despite all of this, the stock market is notching new all-time highs.
If it feels odd, you’re not alone. It’s time like this that exemplifies why it’s so important to stay invested, even when you feel anxious or have a pessimistic outlook for the future. So much more wealth has been created through time IN the market vs. timING the market.
It’s not all doom & gloom though, there have been multiple positive developments taking place. A new tax bill passed this summer was favorable for corporations and a number of foreign companies have made pledges to invest in the U.S. Additionally, the biggest theme in markets right now is the potential for artificial intelligence to deliver massive productivity gains that will add to companies’ earning power.
That said, we are in the early innings of seeing how this new technology will transform industries and companies can change course on a dime. For example, just weeks after Meta sent out massive offers to recruit top talent for their internal AI division, they decided to do a hiring freeze.
One other interesting statistic to point out is that we haven’t experienced a sustained market downturn for more than nine months since coming out of the financial crisis in 2009. Over the past 16 years, we have experienced a handful of market corrections, as defined by a decline of more than 10% from a previous high. While some of these downturns felt scary in the moment, all of them were relatively short lived and in each of these market corrections, “buying the dip” has been rewarded.
Why is this statistic worth sharing?
The average age across all of my clients is 39, meaning that most of them (myself included), have not experienced a prolonged bear market.
This isn’t my attempt to sound the alarm bells, rather, I believe it’s important to proactively educate you on the range of outcomes that are possible when you bear the risk of investing in the stock market.
In my last post, I shared that investors are currently very optimistic about the future based on stock market valuations. As a stock market investor, you have to be optimistic by nature to hand over your money to someone else in the hope of getting more back later. That said, when investors are collectively in an optimistic mood, they often interpret ambiguous developments positively and overlook negatives. As Morgan Housel eloquently states, “risk is what you don’t see”.
As I previously mentioned, elevated valuations does not mean that a market crash is imminent, however, future returns may be more modest than what we have grown accustomed to over the past 15 years. The S&P 500 has returned nearly 15% on an annualized basis over the past 15 years, and 24% annualized over the past 3 years.
Zooming out, the average S&P 500 annualized return has been closer to 10% dating back to 1928 when the index was created. This data validates that:
We’ve had above-average returns for the past 15 years
Investing in the stock market is one of the most persistent methods to generate long-term wealth
One of the factors that has proven to be correlated with future returns is the starting valuation. The graph below is from J.P. Morgan Asset Management and it plots each month between 1988 through late 2014. Each diamond represents the forward Price / Earnings ratio for the S&P 500 at the time and the annualized returns over the subsequent ten years.
The take-aways from my perspective:
There’s a strong relationship between starting valuations and subsequent ten-year returns. Higher starting valuations consistently led to lower returns, and vice versa.
Today’s P/E ratio is well into the top decile of observations.
In that 27-year period, when people bought the S&P 500 at P/E ratios in line with today’s multiple north of 22, they earned ten-year returns between +2% and -2%.
The good news – while the S&P 500 is a popular proxy for the U.S. stock market, the investment approach that I take is not trying to mimic the S&P 500. Three differences that I’ll highlight are:
Exposure outside of the U.S. stock market – The U.S. stock market is the largest market in the world, so I have the largest allocation to U.S. stocks, however 30% of the portfolio are in companies domiciled outside of the U.S.
2. Less Exposure to the Tech Sector – As I mentioned, the tech sector has had the strongest performance and it also has the highest valuations among all sectors. I intentionally have less exposure to the tech sector within the portfolios that I manage, not because I’m bearish on tech. Rather, it’s because a majority of my clients work in the tech sector and receive equity in tech companies, so they already have a lot of exposure to the tech sector and from a risk perspective, there is correlation between your company & the broader tech sector.
3. More Exposure Outside the Largest Companies – The S&P 500 is composed of the largest 500 U.S. companies. However, there are over 3,000 publicly traded companies in the U.S. stock market. Within the portfolio strategy that I manage, my clients own all the companies within the S&P 500 AND many other smaller companies as well. This additional diversification will help returns if the largest companies are not the “winners” of the next decade.
Personally, I haven’t made any changes to my investment account allocations and I encourage the same for each of you. Beyond the additional diversification that I outlined above, within the financial plan, I’ve already accounted for scenarios where future returns are not as robust as what they have been over recent years.
If you happen to come into a significant amount of cash and investing a lump-sum in the stock market gives you unease, I’ve outlined a few alternative actions to consider that are productive uses for improving your financial situation.
Paying Off / Down Debt – Eliminating liabilities increases your net worth and can help increase flexibility with your monthly cash-flow going forward.
Exercising Stock Options – For some of you, buying shares in your company at a discounted valuation may be one of the best risk / reward investment opportunities.
Home Renovations – When things are going well and you’re in a robust financial situation, this is a good time to pursue discretionary home improvement projects.
Shoring Up Your Cash Reserve – A healthy cash reserve doesn’t seem to matter until it’s the only thing that matters. If you don’t already have 3-6 months of expenses built up as a cash reserve, now is the time to replenish your savings.
Building a resilient foundation with your finances is a core part of your overall financial plan. When scary markets come again, it will help you weather the storm.
One theme that persists across all market cycles is that the good times are never as good as they seem, and neither are the bad times as bad as they seem. As a long-term investor, time is on your side and I believe staying invested for decades will continue to bear fruit.