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                                 SOUND ADVICE:  November 11, 2020

 

Why You Should Be Concerned About High Stock Prices 

In the wake of the market plunge that took place in late February and March, the stock market staged an extraordinary comeback.  But even with the breaking news that vaccines now in Phase III clinical trials are showing promising results, we are all better advised to take a deep breath and put things in perspective.

Let’s begin with the reality that just prior to the latest jump in prices, the Standard & Poor’s 500 Index on an equal-weighted basis was actually down for the year to date.  It gets worse since the S&P has been largely driven by the huge advances of the FAANG stocks: Facebook, Amazon, Apple, Netflix, and Google.  Ex those companies, the typical year-to-date result for most stocks was a loss between 5% and 10%. So much for talk about a roaring bull market.

Given this perspective, the question to be asked is whether stock valuations are too high?  This can be viewed in two ways. For the FAANGs, individual valuations range between 30 and 70 times earnings, which some may view as appropriate when compared to projected future growth.  This is debatable.

The current valuation of the S&P 500 is slightly above 21 times, compared with 19 times excluding the FAANGs.  Either way, the numbers are rich, but still well below the astronomical peak of 1999-2000.

The main arguments in support of currently high stock valuations are the continuation of low interest rates and the prospective recovery in post-pandemic earnings.  Add to this the huge jump in the savings rate, which at some point will lead to a big pickup in spending, and the possibility of another major stimulus bill.

There is some merit to this reasoning, but the aftermath of what may be a sugar high late in the second half of next year and into 2022 will probably be a moderation of the pace of recovery.  Since it will take a while for corporate earnings to get back up to the level of 2019, it would be overly optimistic to expect that stock valuations will move ahead quickly.  More likely, there will be continued ups and downs within a broad trading range while the economy gets back on its feet and the devastation among smaller businesses starts to be repaired.

Although many investors would be thrilled to watch the averages climb steadily over the months ahead, that may well be the worst possible scenario. We saw that kind of advance during 1999-2000 and recall far too much talk about how "It's Different This Time." 

Trust me.  It's not.

If I had my druthers, the market would move sideways through the remainder of the year and well into 2021, giving earnings time to catch up.  But more likely, there will be a significant pullback between now and then.  In the past, there has been a correction of 10% or so in two out of three years.

Is this something to worry about?  Not really, though it suggests it would be best to ignore thoughts about missing a rally and instead prepare for the better opportunities that would be available when prices come down to more reasonable levels. 

The problem is that investors tend to do the opposite of what makes sense.  When stocks are on sale, they're too nervous to take advantage of bargains.  Yet when prices soar, they can't wait to pay up.

This behavior is counterintuitive.  In every other part of our financial lives, we look for the best deals.  But with investing, most people tend to buy high and sell low.  Not surprisingly, studies have shown that this tendency usually backfires. The latest Dalbar study of investor returns indicated that the typical investor in equity mutual funds had gotten an annual return of only 3.9% over the last 20 years.  That compares with 5.9% for the S&P 500 and 7.0% for the Dow Jones Industrial Average.                        

When prices are as high as they are now, efforts to dial down risk will probably be well rewarded.  A word to the wise.

N. Russell Wayne, CFP

 


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