Is the US Stock Market Value at its Peak?

Someone came across my blog and asked me this very question about market timing.  I tried to do my best to answer it.  Let me know your thoughts and comments:

From a total market standpoint, there are some valuation metrics that some use to gauge market value. Warren Buffett refers to the total stock market cap/GDP as one metric.  One I catch myself referring back to is from Robert Shiller’s Irrational Exuberance, the S&P 500 real price / adjusted earnings ratio:

Stock market value

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source: http://www.irrationalexuberance.com/

You can see CAPE is above the long-term historic median, but still well below the speculative highs from 1929 and 2000.  With total valuations within the historic range, it is difficult to predict what should happen to market value.  Many forecasters predict long-term interest rates should rise (from historically low levels- see chart), which historically causes equity premiums to decline.  However, there are reasons for persistently low long-term rates (low inflation expectations) and there is little evidence to suggest the market is not efficient.

One point I like to think about is the continually increasing demand for risk-free investments as more and more baby boomers reduce their risk tolerances (scary note: baby boomers hold 2/3 of the U.S.’s total wealth).

I try my best to keep my decisions from being impacted by what I think will happen.  It is very easy to let emotions get a hold, begin to play the market timing game and end up having a detrimental impact on decisions.  My point here is that no one really knows what will happen and having an opinion either way should not necessarily help you.

The calming fact to me is that being over 25 years away from retirement, I know it does not really matter what happens. Comparing every historic 25-year holding period from 1802 to 2009, the annual average return has ranged from 5.5% to 8.3%.  Even if you invested near the peak of the market, your average annual return would have been at worst 5.5% per year (much better than what you’d get while sitting on a pile of cash).

So is the market at a peak? Maybe.  Does it matter to me? Absolutely not.

 Range of stock market annual returns based on holding period 1802-2009

Holding period 1 year 5 years 10 years 15 years 25 years 50 years
Upper 95% 24.8 14.2 11.5 10.9 8.3 7.9
Lower 95% -11.7 -0.6 2.3 2.9 5.5 5.8
Std. dev. 18.3 7.4 4.6 4 1.4 1
source: Common Sense on Mutual Funds, Bogle, 2010

So how to proceed if you are holding too much cash and you are afraid the market will decline?

The easy answer is to identify your target portfolio allocation in aggregate (Vanguard can easily help figure that out for you) and devise a plan for how to get there.  If it is a substantial sum, plan to dollar-cost average in with equal amounts once or twice monthly over 6-12 months.  Choose what makes you comfortable with the approach.  If you adopt a sound strategy with the overall goal in mind, you will never be second guessing your decisions and will be way better off than the majority of folks.

 

The Significance of Fund Expense Ratios

The median expense ratios for all U.S. equity and bond funds have been declining steadily since the inception of (and growing popularity of) index funds.  According to analysis provided by ICI, median expense ratios have continually trended lower since 2000 (see Chart 1). The median expense ratios for index bond funds and index equity funds are 0.11% and 0.12% respectively.  Interestingly, bond index funds have expense ratios that are still 50 basis points below the expense ratio for actively managed bond funds.  Stock index funds have expense ratios 75 basis Read more

Return on Investment for Various Assets

Return on investment has varied dramatically across asset classes.  Cumulative total return on investment of $1.00 in stocks have outperformed those for gold by over $480K in the 206 year period from 1802 to 2008! Similarly, stocks outperformed bonds by nearly 3% points per year which equates to $479K  over 206 years.  Below is a table on the compounded total return on $1.00 invested in various asset classed:

Total Real Return on Investment of $1 (1802-2008)

Asset Real Total Return Annual Growth Rate
Stocks $480,873 6.5%
Bonds $1,577 3.6%
Bills $306 2.8%
Gold $3 0.5%
Dollars <$0.10 -1.1%

Source: Common Sense on Mutual Funds, J. Bogle 2010

Using data from Irrational Exuberance (R. Shiller), the US real home price from 1890 to 2014 appreciated from $1.00 to $1.34, an annual compound growth rate of 0.25%.  While this is not over the same period of time, it is evident that homes have no real return on investment  over a long period, especially when considering the available alternatives.

Never Invest in the Commodity Market

Stating the obvious sometimes seems unnecessary.  Yet, people are willingly buying into the fad of ever more specific ETFs being created in seemingly every permutation of underlying asset classes which now unfortunately includes commodities.  If you put something in their face, they will buy it. There is no rationale for adding room for passively adding commodities to your portfolio.  Veer clear of the commodity market.

The slight benefit of improved diversification is outweighed by the huge drawback of it providing no real returns with sometimes large volatility.  Commodities do not generate income like other assets and rely solely on the greater fool theory to ever make a profit.  To read a more eloquent rationale for avoiding gold, check out Warren Buffett’s 2011 Letter to Shareholders:

http://www.berkshirehathaway.com/letters/2011ltr.pdf

Ignore for a second the high management fees, low trading volume, and wide bid/ask spreads.  Who would choose to “invest” in an asset that has performed just marginally better than cash over the last 200 years (see Common Sense on Mutual Funds by J. Bogle)?  To make matters worse, the commodity market can be subject to significant volatility and thus a speculative commodity position offers atrocious risk-reward ratios.

Heretofore, to avoid confusing the reader I will refer to speculating in commodities as hoarding instead of using the term “investing.”

Common Mistakes in Asset Management

Understanding the basics of asset management is a necessity to building personal wealth. Individual investors can make irrational and costly decisions that otherwise could have been avoided.  Too often, people are able to prudently save excess cash to invest, but having no experience or interest in making an educated decision, they end up making foolish mistakes.  Below is a list of the most common mistakes:

  1.  Holding too much cash.

The first mistake is remaining too risk averse and never building a portfolio at all.  While it is strongly recommended to create an emergency fund in addition to having liquidity available for expenditures, at some point you need to put your excess cash to work and begin asset management.  Prudent budgeting should help you determine how much to hold in reserve and when to look into assets with higher rates of return. Read more

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