Do You Think Stocks Are Too Expensive?

By Kate Warne October 02, 2017

stock market

Do you think the stock market is too high? Investors are more optimistic than in the past few years, cheered by better global economic growth and the anticipation of lower tax rates. As a result, U.S. stocks have reached many all-time records this year, supported by double-digit earnings growth for the S&P 500, better revenue growth and still-low interest rates.

Low volatility has lasted longer than many expected, but pullback predictions have increased, citing above-average valuations, heightened political uncertainty and the transition to less support from the Federal Reserve. To prepare for a possible pullback, our recommendation is to add fixed-income investments where appropriate.1 Bond prices frequently rise when stocks drop, and that relationship can help reduce your portfolio’s volatility.

How high is too high?

Over time, the stock market has reached new records, powered by economic and earnings growth.2 We expect both to continue: The domestic economy is picking up a little speed, helped by improving growth in the rest of the world, and company earnings have benefited from better sales, the weaker dollar and still-low interest rates. That’s why we expect the bull market to continue and recommend adding a mix of large-, mid- and small-cap U.S. equities as well as international equity investments.3

But valuations for U.S. stocks are also near all-time highs when you compare stock prices to earnings or some other measures. Based on many valuation measures, stocks have been fairly expensive for several years. But this doesn’t mean stocks have gotten too high or you should sell now, in our view.

Remember, above-average valuations:

  • Aren’t a sign of future volatility – Valuations haven’t been helpful in predicting short-term market moves in the past. Pullbacks of 10% or more have happened almost every year, regardless of whether valuations were high or low.
  • Don’t predict short-term stock returns – Valuations also haven’t predicted past short-term market returns. The S&P 500’s price-to-earnings ratio has been above-average since June 2014, and the total return over those three years was 34%. If you waited to invest in stocks, you missed that opportunity.
  • Are followed by lower long-term returns – High valuations have frequently been followed by below-average stock returns. That’s one reason we think long-term returns on U.S stocks won’t match their past performance.
  • May indicate adding fixed income – When stocks rise sharply, your portfolio may need to be rebalanced by adding fixed income, returning it to the mix that fits your comfort with risk and long-term financial goals.

Why add fixed income?

This extended period of extremely low interest rates worldwide has led some to worry about the risks of owning bonds, particularly if interest rates rise sharply. We don’t think that’s likely because the Fed plans to continue to move cautiously. It will start reducing its bond holdings and keep raising short-term rates slowly and hesitantly as long as inflation doesn’t rise sharply and the economy grows modestly. Slow rate increases mean bonds can continue to provide income and reduce portfolio volatility as they’ve done in the past.

Investors know that long-term, stocks generally outperform bonds. In fact, the average return for stocks was 11.5% vs. 7.5% for bonds since the beginning of 1976.4 But performance over short time periods highlights that stocks and bonds take different paths. Stock returns vary greatly from year to year, and as a result, bonds outperformed stocks in about one-third of the past one-year time periods, helping stabilize portfolio values when stock returns were small or negative.

Expect pullbacks

Since 1970, stocks experienced some sort of decline during almost every calendar year. The average drop was 14%, but in most years stocks rebounded, finishing the year higher in 24 of the past 32 years.2 Smart investors realize that such pullbacks are frequent, not a reason for concern, and can offer opportunities to add attractive investments at lower prices. Instead of worrying about pullback predictions, prepare to “buy the dip” if appropriate for your situation.

More normal stock market volatility is likely to return, and that could mean more frequent pullbacks. If you’re concerned about the short-term outlook for stocks, talk to your financial advisor about whether it makes sense for you to add diversified fixed-income investments. But don’t avoid stocks — instead, consider buying quality investments during pullbacks. Better earnings and modest economic growth can support rising stock prices over time, even with above-average valuations.

Important Information:

1 Before investing in bonds, you should understand the risks involved, including credit risk and market risk. Bond investments are also subject to interest rate risk such that when interest rates rise, the prices of bonds can decrease, and the investor can lose principal value if the investment is sold prior to maturity.

2 Past performance is not a guarantee of how the market will perform in the future.

3 Investing in equities involves risks. The value of your shares will fluctuate, and you may lose principal. Small and mid-cap stocks tend to be more volatile than large company stocks. Special risks are inherent to international investing, including those related to currency fluctuations and foreign political and economic events.

4 Source: Morningstar Direct, 1/1/1976-7/31/2017. Stocks represented by the S&P 500 total return index. Bonds represented by the Barclays U.S. Aggregate Bond Index. Investment indexes are unmanaged and are not available for direct investment.

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