June 1st, 2017 | by Gregg S. Fisher, CFA, "Invest with Reason"
Fear of (Market) Heights
- US equity market valuations, many at all-time highs, are stoking investor fears of an impending correction.
- The notion of over/undervalued markets is a complicated one; research has found as many instances of markets continuing to appreciate well beyond “peak valuations” as instances of major corrections following such heights.
- Investors would be well served to avoid allowing market valuations to drive buy and sell decisions.
- Just as we advocate against market timing, Gerstein Fisher does not recommend that investors try to “game” various investment factors, such as value and momentum, as these inevitably swing in and out of favor over time; our research has shown that a sounder approach is holding a diversified, multi-factor portfolio.
In recent days, all of the major US stock indexes have hit all-time highs. Investors with acrophobia are anxious that US markets are overvalued and ask whether it’s time to pare allocations or even to exit US stocks entirely. I addressed the knotty issue of market valuation at an event we hosted in early May, “The Future of America, In Context,” and will provide some perspective on the question of the valuation signal in this and in my next column.
The concept of over- or underpricing—the notion that the market price is “wrong”—is a delicate matter. To be sure, there are multiple yardsticks with which to measure market valuations, and most of these would indicate that today’s US market is richly priced by historic standards. For example, Exhibit1, which depicts market valuations back to 1881 using Robert Shiller’s Cyclically-Adjusted Price-Earnings (CAPE) Ratio, tells us that the price-earnings ratio of today’s S&P 500 Index is more than 50% higher than the historic norm.
What Inning Are We In?
Frustratingly, even if one is armed with this knowledge, we do not know of a robust, successfully tested investment strategy that would make one a successful market timer. In researching the issue, we have found that there are as many periods when markets continue to advance substantially after “peak valuations” as there are times when markets correct after reaching such heights.
For example, in 1996, when the market’s price-earnings ratio according to Shiller’s metrics crossed 30, Federal Reserve Board Chairman Alan Greenspan delivered his famous “irrational exuberance” speech, in which he warned about an expensive stock market. With the benefit of hindsight, we can now say that it would have been a mistake to listen to him: during the ensuing three years the market surged more than 100%. Despite two epic market crashes since Greenspan’s celebrated speech, if you had just held on to the S&P 500 Index, your annualized return during the following 20 years would have been 8%, which is just two points shy of the historical average.
We are now in the ninth year of a bull market, and many observers think we’re overdue to take a breather. Maybe we will; maybe we won’t. Looking back at history, we can find periods when stocks rose—with some bumps along the way—for far longer than most people imagined possible. For instance, 1942 to 1966 was a 25-year period when the S&P 500 Index returned 3000%; from 1974 to 2000, the market basically performed the same 30-fold return trick.
The moral of the story is that, unfortunately for nervous investors, all-time market highs do not seem to contain compelling information on which to base a decision on whether to stay invested or not. In baseball parlance, we don’t know if we’re only in the fourth inning or the ninth inning of the game, but I do advise exercising caution before making market-timing decisions simply because the market seems high.
Conflicting Signals: Better Together
Before closing, I would like to introduce a market-timing study we conducted that supplements some points I have made above. In the study’s Value Strategy, investment decisions were made purely on the basis of fundamental valuation. Specifically, for this test we sold the portfolio whenever the CAPE Ratio exceeded 25 and reinvested when it fell below 25. The Price Momentum Strategy essentially ignored fundamentals and traded on price movements: for the study, we sold when the S&P 500 fell below its 3-year moving average level and bought when the Index rose above the 3-year average. For the third and final portfolio strategy, we created a buy-and-hold portfolio that equally weighted both the Value and Momentum factors.
As Exhibit 2 illustrates, investing simply on the basis of valuation—as opposed to multiple factors—turned out to be a very poor approach. For example, using this mechanical valuation tack an investor would have been out of the market from January 1997 to June 2002, when the S&P 500 Index returned 43%; he would have been in the market for only five months between October 2003 and December 2007; and the investor would have missed the market gain since November 2014.
Momentum performed much better than Value—markets often run up for longer than many investors expect—and the momentum signal did help investors avoid the worst of some severe bear markets (from February 2001 and June 2008). But the best performer by far was the strategy that incorporated both fundamentals and price, the multi-factor, buy-and-hold portfolio. This reinforces the point that it is unwise to consider only one investment factor in isolation—and that market-timing efforts can be hazardous to building long-term wealth.
Two elements I have not addressed here are equity portfolio diversification and rebalancing—for example, ensuring that an investor holds a sufficient allocation of foreign stocks. I will turn to the topic of international investing in the next installment in this series. Meantime, if you would like to learn more about the investment, economic growth, and political subjects we discussed at our May conference, I invite you to read an extensive summary of the event: Real Talks: The Future of America, in Context.
 Valued defined as P/B and P/E
 Momentum defined as 12-month relative strength