Should You Invest At All-Time Highs? [Redux]

We’ve all been here before.

Not only is the stock market at an all-time high, but valuations are also creeping higher.

In other words:

Yes, S&P 500 index is at ~6500, and that’s a bigger number than ever before. But if our companies are earning more money than ever, then we should be at an all-time high, right?

That’s why valuation matters. It’s not just the price (~6500) that matters, but also the companies’ earnings. One simple valuation metric is “price to earnings,” or “P/E.” It’s a fraction dividing the market’s total price by the market’s total earnings. 

And when we look at THAT metric…

We’re also creeping uncomfortably higher. Most of the market’s history shows P/E ratios in the range of 10 to 20. And large P/E spikes tend to be followed by large P/E crashes. When the P/E crashes, usually it’s the price (a.k.a. our portfolio values) that takes the brunt of the pain. Ouch.

What does this mean for us? 

Bonus reading – the original “Should You Invest at All-Time Highs?”

What Should We Think About “High P/E?”

When the P/E ratio is high, it means investors on the whole (including us) are valuing stocks right now based on big future hopes. 

The current P/E ratio of 30 means we’re buying stocks at a price that is 30x higher than one year of earnings. Or, if earnings never change, it would take these companies 30 years to pay us back for our investment.

Baked into high P/E ratios is the hope for future growth. It means companies need to overachieve to make up for today’s higher-than-typical price. The earnings must grow (and quickly) to turn the 30-year expectation I just outlined into something shorter.

Lemons

Imagine my lemonade stand earned $100 this past summer. 

Investor A says, “I’ll buy your stand. But lemonade is a dying business. Maybe I can repeat your earnings for one more summer, but soon after I’ll get out-competed. I’ll buy your stand for $100, make my money back next summer, and after that I might turn some profit. My offer to buy you is $100. But not a cent more.”

That’s a price ($100) to earnings (also $100) ratio of 1. 

But then investor B comes along and says, “Lemonade is a gold mine! We can expand your operations by 10x and carry forward for the next 50+ years, making $1000’s every summer! This year was just a proof of concept. This company is easily worth $10000 – and it’ll make me a millionaire in the long run.”

That’s a price ($10,000) to earnings ($100) of 100.

Investor A has a low valuation. 

Investor B has a high valuation. 

Some would call investor A a pessimist. 

Others would call investor B an optimist. 

Both adjectives can be correct. 

The market, famously, has tendencies to go to both extremes. Unjustified pessimism and irrational exuberance. 

Right now, at least compared to historical markets, the optimists’ votes are winning. Some (or most) might even be irrational. Which, suffice to say, could be a reason to consider selling your stocks. The market cannot stay irrational forever, thus a correction / bear market / crash is bound to happen. 

Maybe. 

Do Modern Companies Deserve A Higher P/E?

Some smart people believe “this time is different.”

I know, I know. Those are, indeed, dangerous words. 

Their belief is that our modern foundational companies generate revenue in a way that is both more effective and more sustainable than ever before.

They believe Apple, Google, Microsoft, NVIDIA, and even smaller companies *deserve* a higher P/E because they are simply better and more consistent at making money than companies of the past. 

Some of that has to do with the products themselves. 

It’s 1920. You’re Bethlehem Steel. And you’re looking to double production over the next decade. You need new foundries, and that is expesnive! Those capital expenses (“cap ex”) are risky for investors. Warren Buffett said about cap ex:

“We still love a business that takes very little capital and, earns high returns, and continues to grow, and requires very little incremental capital.”

High cap ex? Unattractive investment.

But what if you’re Microsoft and looking to double your software sales over the next decade? Sure, you need some marketing and sales dollars. But it’s pretty cheap to simply sell more software licenses.

And because Microsoft’s earnings are easier to grow than Bethlehem Steel’s, some say Microsoft (and many other modern companies) deserve a higher multiple than those of the past. These modern companies’ future earnings are more dependable and easier to grow, thus investors should be willing to pay more (higher price) for them today.

Another interesting reason: perhaps corporate America is simply better at running big companies than ever before. More efficient and effective at understanding how to drive profit back to shareholders. No moral judgment, just a statement of fact. 

But still – with market valuations so high and the debate whether that’s deserved or not, do we all need to do something about it? 

Is It Time to Sell Some Stocks?

Should you sell your “overvalued” stocks? After all, “sell high,” right? Before you make a decision, think through these reasons below.

Rebalancing

If you’re rebalancing, you’ve already got “sell high” built in to your investing. As stocks rise in value (especially as compared to other assets you might own, like bonds), the act of rebalancing will address the problem of overvaluation.

You’ll sell overvalued assets and buy undervalued ones. The goal here isn’t always to maximize long-term returns. Oftentimes, in fact, rebalancing leads to lower long-term returns. But instead, the goal is to mitigate the impact of a potential crash.

What Does Your Plan Need?

What does your plan need? Do you need to own all the stocks you own, especially after a decade-plus of (arguably) overperformance has led to their overvalued nature?

If your assets and future liabilities are aligned, I’d say you’re all set.

Remember: need, ability, and willingness. That’s what every investor needs to know about themselves and their financial plan.

Granted, if your willingness for risk is dampened due to high valuations AND your need is satisfied with a lower stock allocation, I’m all for trimming your stock position. 

Ask Yourself: “What Then?”

If you sell some stocks right now – what then? Or, more simply, if you just want to sit on cash instead of deploying it into the market…what then?

Do you have a plan to reinvest later?

Is that plan based on…specific time intervals? Or specific valuation metrics? Or just…how you feel?

Speaking of – will you feel ok if you end up breaking your plan, taking evasive action, and get it wrong? 

How many times in the past have you successfully figured out this type of timing? When to sell, when to buy…?

How Has This Worked In The Past?

Is there historical precedent that we can “sell high” based on valuation and look smart in the long run?

I know. The past isn’t prologue, especially in investing. Past returns don’t predict future results. Nevertheless, historical backtesting is one of the better, data-driven tools we’ve got.

Imagine a hypothetical investor from our past. A person who dealt with similar situations as the one we’re in right now. If that person had done the laziest thing possible – never sold – what would their next year(s) returns look like? Let’s dig in.

I looked at any month in S&P 500 history when the P/E ratio was higher than 24. For the sake of this backtest, that’s our “we’re overvalued” trigger. Then I asked, how did the S&P perform over the next 1 year, 5 years, 10, 15, and 20 years?

Note: all of the performance numbers below are inflation-adjusted, as the data comes from Robert Shiller’s data set. Thus, a “7% real return” represents a scenario where the market returned, say, 10% and inflation was 3%. Be careful how you account for inflation in your retirement planning.

The results?

Over the next year, the next five years, and sometimes even the next ten years, an “overvalued” stock market typically has positive returns, but has sometimes performed poorly.

The chart below shows the cyclically adjusted P/E ratio (CAPE). The x-axis is CAPE, and the y-axis shows the future 10-year returns. You can see the trend…as the CAPE increases, future returns decrease. If you pay more for the lemonade stand today, your future profits decrease.

For example, investors in 1998, 1999, and 2000 were unaware that their next decade would see two significant crashes. Their 10-year, inflation-adjusted returns are in the range of (-3%) to (-5%) per year over that period. Ouch!

But that particular negative result is partially due to “data semantics.” That (arbitrary) 10-year timeline just so happens to capture both the Dot Com Bubble and the darkest depths of the Great Financial Crisis.

If we simply extend that timeline to an equally arbitrary 13 years, allowing me to cherry-pick some post-GFC recovery years, our same investors see average real returns of 0% to 2%.

I know, I know…a 1% annual real return over a 13-year period isn’t what we hope for. But it beats inflation, it beats cash, and that’s starting with an initial condition of overvaluation, and suffering through two major crashes in the process.

Yet that long-term investor still “wins” against inflation, thus making progress on their long-term goals!!!

Let’s stretch out to 15 or 20 years. We reach the same conclusions that all long-term stock analyses reach. Positive real returns win out. The median scenarios here provide a 5% annual real return. Starting from a high valuation dampens some return expectation (after all, the long-term average for all starting scenarios is ~7% real returns [10% nominal minus 3% for inflation]).

But, again, a positive real return allows the long-term investor to progress on their goals.

In conclusion:

• Investment returns from “today’s starting point” of high valuations can be choppy in the short run. But it can also be fine in the short run! Hmm. It’s hard to decide whether selling for the short term is right or wrong, especially if you already own cash or bonds to cover expenses over that time.
• Returns can be choppy over 5 years or 10 years. But usually not. Holding for the next 5 years seems smart, especially if you own cash or bonds to cover expenses over that time.
• Returns are consistently strong over 15 or 20 years, or more. Holding for that period seems smart. 

Should you sell right now?

Maybe. Sometimes in the past you would have been smart to do so. But, all else equal, the odds are actually against you. And then you must get your timing right when buying back in.

If you zoom out far enough, the odds are very against you.

History says to hold. 

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