How To Invest When Stock Valuations Appear Stretched

U.S. stock valuations are extremely high on historical measures. What should an investor do?

The Valuation Argument

The data behind stretched valuations delivering lower returns over time is pretty robust, though it generally plays out over many years, not months.

There is empirical support, but it also stems from the core concept that any investment is worth the cash it gives you over time. Think about it, if an investment never offered the prospect of a cash payout, why ever hold it?

As a result, the market yielding 2% is less attractive than a market yielding 5% all else equal. Of course, it’s not quite that simple because, for example, stock buybacks can help returns too, and some companies have better opportunities to invest than to pay out dividends.

Now, if we examine many measures of the U.S. market we see that stocks do look expensive. The average yield on the S&P 500 over history has been around 4%, it’s currently half that. Then whether you look at the current PE or the Shiller PE, the market is trading at around double average levels.

Plus, it’s important to remember that we’re talking averages here, the market has spent a lot of time below its average valuation levels. The average is hardly a floor for valuation, it’s closer to a mid-point. A market trading at more than double its historical valuation could easily more than half in valuation terms.

Counter-points

Now, this logic has its limits. Maybe things are different now, maybe monetary and fiscal policy are now more sophisticated. Perhaps companies are more shareholder-friendly and profit margins are sustainably high. Maybe low bond yields and controlled inflation mean that you should pay more for stocks. Maybe the U.S. tech giants really are fantastic companies that will see years of attractive growth with low capital intensity and clear moats to protect their businesses.

However, looking over multiple decades of history includes high inflation and low inflation, different policy regimes and growth outlooks and across many many public companies. It is perhaps hard to argue that today’s environment is a great departure from history, and hence its likely historical data is useful. What history suggests, is that on average, over the next few years, it’s more likely that valuations fall back to more normal levels consistent with history, rather than skyrocket to levels we’ve never seen before, except maybe briefly in Japan.

What To Do

Of course, the challenge is how to invest in such an environment. Here there are a few strategies to consider.

Focus On Value

A lot of the premium valuation in the market today is due to tech valuations. By avoiding these names and focusing on more value-oriented investments, you may have some protection if valuations do decline. This is not foolproof as value stocks may decline too if the market does, however, as after the 2000 dot com bubble, value stocks may enjoy a better run in a bear market.

Diversify Internationally

Diversifying your stock exposure can help manage risk. It can also be helpful today because though U.S. stocks are expensive, international valuations may be more reasonable. For example, according to StarCapital’s research the U.S. might actually now be the most expensive market in the world on a composite of valuation measures.

Other countries have lower valuations, or may even be cheap. Looking at international ETFs and other ways to gain exposure outside the U.S. may offer some insulation from expensive U.S. stock valuations.

Consider Other Assets

A final strategy is to diversify beyond stocks. This is challenging because over time stocks have been a great, if volatile asset class. Still, adding other assets to your portfolio such as fixed income, commodities, property precious metals and even cryptocurrencies can help manage risk over time. Yes, stocks perform well in bull markets, but just as with value or international stocks these assets may preserve value better in a bear market.

Still there are challenges here too, fixed income yields are extremely low and property values are not necessarily cheap either. In a sense, we are in an environment when the price of many assets does appear inflated.

Final Thoughts

The research behind valuation driving stock returns is pretty robust. It does seem likely U.S. stock returns could ultimately lag over the next several years, though we don’t know when and, perhaps this time will be different. Though, of course, those are dangerous words in finance.

Fortunately, the strategies of including value in your portfolio, diversifying internationally and considering other asset classes and generally considered sound investment principles that can be implemented at relatively low cost. So it may be helpful to consider them for your portfolio, even if the U.S. market didn’t appear notably expensive today.

By Simon Moore, Senior Contributor