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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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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.