The answer is very nuanced.
One of the questions I’m asked with great frequency is to describe how market valuations should impact your financial plan. As I discuss in my book, “The Only Guide You’ll Ever Need for the Right Financial Plan,” there are three very important factors to consider when developing your financial plan, and specifically in determining your asset allocation. They are: the ability, the willingness and the need to take risk.
The ability to take risk is determined both by your investment horizon and the stability of your labor capital. The willingness to take risk (risk tolerance) is determined by your stomach’s ability to handle the stresses caused by bear markets. And the need to take risk is determined both by your spending requirements (the higher they are, the greater the need) and the expected rate of return on your investment choices (which are determined by market valuations and bond yields).
Thus, valuations (and bond yields) should impact your asset allocation decision, and you should review your plan on an ongoing basis because valuations and yields change over time. Having said that, I want to be clear that, with rare exceptions (to be discussed later), stock market valuation metrics (such as price-to-earnings (P/E) ratio) shouldn’t be used to time the market.
In other words, a higher-than-average P/E ratio shouldn’t be treated as a signal to sell, despite what prominent market prognosticators such as Jeremy Grantham and John Hussman do. Nor should a lower-than-average P/E ratio be treated as a signal to buy.
High P/Es Don’t Justify Market Timing
Even though a high P/E ratio—at least within a very broad range—is a good indicator that future returns are likely to be below average, there should still be an equity risk premium. Stocks should still be expected to outperform riskless investments, such as Treasury bills.
The exception to this dichotomy would be when there is a very clear bubble, like the one we had with growth stocks in the late 1990s. There was no way to justify the Nasdaq-100’s earnings yield (or E/P ratio) of about 1 percent, nor the S&P 500’s earnings yield of about 3 percent, when Treasury inflation-protected securities (TIPS) were yielding around 4 percent.
But even then, if you sold your position, at what level do you buy back in? Market timing is a very slippery and dangerous slope, which is why so few succeed and why Warren Buffett advises against it.
However, we do know that high valuations mean that future expected returns are low, and vice versa. Thus, valuations do impact the need to take risk. And the same is true of bond yields.
Pay Attention To Prices
When forecasting investment returns, many individuals make the mistake of simply extrapolating recent returns into the future. Bull markets lead investors to expect higher future returns, and bear markets lead them to expected lower future returns. But the price you pay for an asset also has a great impact on future returns. Consider the following evidence:
The average historical P/E ratio for the market has been around 15. A study covering the period from 1926 through the second quarter of 1999 found that an investor buying stocks when the market traded at P/E ratios of between 14 and 16 earned a median return of 11.8 percent over the next 10 years. This was remarkably close to the long-term return of the market. The S&P 500 returned 11.0 percent per year for the 74-year period 1926-2000.
On the other hand, investors purchasing stocks when the market traded at P/E ratios of greater than 22 earned a median return of just 5 percent per year over the next 10 years. And investors who purchased stocks when the market traded at P/E ratios below 10 earned a median return of 16.9 percent per year over the next 10 years.
CAPE Ratio A Useful Indicator
We also have evidence of how the 10-year Shiller CAPE (cyclically adjusted price-to-earnings) ratio should impact expected returns. When the CAPE ratio was below 9.6, 10-year, forward real returns averaged 10.3 percent. In relative terms, that is more than 50 percent above the historical average of 6.8 percent (9.8 percent nominal return less 3.0 percent inflation).
The best 10-year real return was 17.5 percent. The worst 10-year real return was still a pretty good 4.8 percent, just 2 percentage points below the average, and 29 percent below it in relative terms. The dispersion between the best and worst outcomes was a 12.7 percentage point difference in real returns.
- When the CAPE ratio was between 15.7 and 17.3 (or generally in the area of its average of 16.5), the 10-year forward real return averaged 5.6 percent. The best and worst 10-year forward real returns were 15.1 percent and 2.3 percent, respectively. The dispersion between the best and worst outcomes was a 12.8 percentage point difference in real returns.
- When the CAPE ratio was between 21.1 and 25.1, the 10-year forward real return averaged just 0.9 percent. The best 10-year forward real return was 8.3 percent, still above the historical average of 6.8. However, the worst 10-year forward real return was -4.4 percent. The dispersion between the best and worst outcomes was a difference of 12.7 percentage points in real terms.
- When the CAPE ratio was even higher, above 25.1, the real return over the following 10 years averaged just 0.5 percent —virtually the same as the long-term real return on the risk-free benchmark, one-month Treasury bills. The best 10-year forward real return was 6.3 percent, just 0.5 percentage points below the historical average. But the worst 10-year forward real return was now -6.1 percent. The dispersion between the best and worst outcomes was a difference of 12.4 percentage points in real terms.
Equity Valuations Matter
What can we learn from the above data? First, starting valuations clearly matter—a lot. Higher starting values mean that future expected returns are lower, and vice versa. However, there continues to be a wide dispersion of potential outcomes for which an investor must prepare when developing an investment plan.
Here’s the bottom line: Periods of higher-than-expected returns lower the need to take risk for investors who have already accumulated substantial assets. Such investors should consider taking advantage of that situation to lower their equity allocation. Investors who did so following the bull markets of the late 1990s, and after the period from 2003 through 2007, were much better positioned for the bear markets that followed. They experienced smaller losses than they would have otherwise.
On the other hand, for investors in the early stages of their investment careers and far from achieving their goals, bull markets are bad news because they raise the need to take risk. They require such investors to increase their exposure to equity risks to make up for the now lower expected returns. Or, alternatively, they could lower their goals, save more or plan on working longer.
Of course, the reverse is true of bear markets. They may raise the need to take risk for those who had already accumulated substantial wealth, while lowering the need to take risk for those in the early stages of their investment careers, because expected returns are now higher.
These are simply facts. However, they don’t mean that when valuations are high, and your need to take risk has increased, that you should automatically go ahead and take more risk. In addition to considering your ability and willingness to take risk, it’s also important to keep in mind your marginal utility of wealth.
Ask yourself: Is the extra risk I have to take to achieve my goal worth the expected (but not guaranteed) extra wealth? Or should I lower my goals, or increase my current savings levels so I don’t need to take as much risk? Or, plan on working longer? Helping investors to understand the math, and helping them understand the consequences of their decisions, is how a good advisor adds value.
Bond Yields Matter Too
The same principles apply to the bond side of a portfolio. For example, if real interest yields are high, you have a lesser need to take equity risk, and vice versa. Thus, as real yields change, it may require that your investment plan adapt to the new environment.
For example, today we have very low real yields on TIPS, and also very low expected real yields on nominal bonds. That increases the need to take equity risks, term risk and/or credit risks. For the record, I would not recommend taking credit risk. If real rates rise, that will lower the need to take equity risk. Thus, a plan that’s developed today should adapt to future changes in assumptions.
A good way to address issues surrounding the need to take risk is to run a Monte Carlo simulation every few years, or whenever returns are much different (higher or lower) than your original plan anticipated. If the original assumptions (inputs) no longer apply, the plan should be reviewed.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.