As the global pandemic extended into 2021, the markets continued the remarkable run that began the third week of March 2020. Since that time, US large company stocks, as measured by the S&P 500 Index, have more than doubled in value.
For 2021, the broad US stock market generated a positive return of more than 25%. Outside the US, the stocks of international developed nations significantly lagged their US counterparts, but ultimately produced a positive return of about 12%, while emerging market stocks ended the year in negative territory. In addition, with the threat of inflation and rising interest rates, bonds declined slightly.
We embarked on 2021 hoping for some normalcy. But instead, it was characterized by continued uncertainty and anticipation. Investors sought signals as to which way the global economy and markets were headed and just when it seemed like an economic rebound was in store as lockdowns were lifted and vaccines were distributed, Delta and Omicron variants emerged and threatened setbacks. However, despite the labor shortages, supply chain issues, rising inflation, and political turmoil, global GDP grew, US corporations reported record profits and consumer spending trended higher throughout the year. The equity markets continued their upward trajectory and continually reached new highs. We know that the economy reflects current conditions whereas markets are forward-looking, but one cannot help but wonder how long this can continue.
Are stocks too expensive? Is the market overvalued? Should we get out now in anticipation of a pull-back in prices? Should we expect lower returns going forward?
First, keep in mind that we choose to invest in stocks because we believe that they are priced to deliver a positive return. Therefore, an increasing stock price is what we would expect to happen (you invest in a stock because you think its price will go up). So, in and of itself, the market reaching new highs is not a reason for concern; it is actually to be expected and it is not predictive of future returns.
Second, stocks are not under or over-valued. The value of a stock is determined by the cumulative wisdom and preferences of thousands of market participants. History has shown that trying to time the market based on valuations is not a reliable strategy. However, valuations can be useful as a tool for forecasting future expected returns by asset class.
Third, while some stocks may be considered “expensive” because they are trading at high P/E ratios,1 this is not true of all stocks. Currently, the “forward P/E” of the S&P 500 is about 21, well above its historical average of 15.5. The growth stocks within the S&P 500, led by companies such as Apple, Microsoft, and Tesla, are trading at a P/E of 27 times forward earnings! However, if we look beyond these headline stocks and the widely followed S&P 500, we can see that valuations, as measured by “P/E”, are at normal levels in most other asset classes, including US small companies (15.5x), “value” stocks (17.1x), non-US stocks in the developing world (15.5x), and in emerging markets (12.4x). (Source: Clearnomics Market and Economic Chartbook, 1/17/2022)
Fourth, valuation “spreads” are wide. P/E and other valuation ratios can also be examined on a relative basis by looking at the valuation “spread” between different assets classes. For example, at the end of 2021, the P/E ratio of US large growth stocks was 28, while the P/E ratio of US small value stocks was less than 13, representing a valuation spread of about 15. While there is always a spread between value and growth, a spread of this magnitude has not been observed in decades. The bigger the spread, the greater the potential premium for owning the stocks with the lower P/Es or valuation ratios. (Source: Clearnomics Market and Economic Chartbook)
So how can we use this information and what does it mean for your investment plans going forward?
Because we cannot predict the nature or timing of the next crisis or how investors will respond to that event, we can use our knowledge of how markets operate and how stocks are valued to fine-tune our financial plans and expectations for asset class returns. For example, in 2022, along with new projections for inflation, we will incorporate lower returns going forward for “expensive” US large-company growth stocks and higher returns for other asset classes with much more reasonable valuations (such as value stocks and non-US stocks).
In addition to modifying return expectations, we can use the pricing information we observe coupled with the knowledge that you have a diversified portfolio, to provide peace of mind. When the new highs and sky-high valuations make us feel nervous, we can feel good about how a globally diversified portfolio extends into asset classes that are much more reasonably priced than many of the growth stocks so often touted in the news media.
As the past two years have reminded us, no one knows for sure what will happen. That is why diversification in the face of uncertainty is so crucial, and adhering to a coherent, evidenced-based strategy puts the odds of success on our side. This approach has not only helped us navigate the unchartered waters of the last few years, but it has also brought us closer to our destination.