If you have not yet read parts 1 and 2 of this series, you might want to take a glance at them before reading this as the below discussion should then make much more sense.....
In the first 2 parts of this series, we examined the utility of using various valuation metrics as the foundation for tactical asset allocation decisions. In simpler terms, we attempted to answer whether or not current valuations matter when managing your asset allocation strategy. Our research seemed to indicate that using one metric in particular - the Shiller PE/10 ratio - could potentially have a positive impact when applied in a disciplined manner. On the other hand, we found that our feelings about current valuations - based solely on recent performance - might lead to decisions that are actually detrimental. Today we will share our thoughts on the current environment, incorporating much of the last 2 discussions in the process....
If you were to look at historical data on the Shiller PE Ratio (simply search "Shiller PE" and you will find plenty of information), something very interesting has occurred in the past 20 years. Between the years 1882 and 1992, there were exactly 15 years where the Shiller PE on the S&P 500 began the year at a level of 20 or higher. However, since 1993, there has been only ONE year that began at a level UNDER 20! Read that again - it is a remarkable phenemenom. So something has to give, right? Many proponents of Dr. Shiller's metric believe that we are on the brink of either a major collapse, or a very long period of miniscule returns - either of which would result in a return to the mean.
There are most certainly those that question the utility of the metric. One argument against using the metric in today's environment is that because it incorporates the last 10 years of earnings - and given the crash in earnings that occurred during the "Great Recession" - it is showing readings that are artificially high. While that may or may not be a valid argument, it still doesn't explain the elevated levels prior to 2007. Some argue that because the metric is adjusted for inflation - and we have been in a very low inflation environment for quite some time - it has caused current readings to show as abnormally elevated. True again, but I don't believe that this is the only period of below normal inflation that we have experienced dating back to 1882 - so not sure that this argument is sufficient enough.
It then occurred to me that something else was beginning to occur in the early 90's - about the same time that Shiller PE levels were expanding for good. Generally speaking, it was about that time that the Fed (and Congress in various ways) began actively assuming mandates other than inflation management (home ownership, employment levels, etc). Simply stated, we began a period of VERY "easy" monetary policy. We know what the Fed and/or Congress did to assist in the creation of the greatest real estate bubble in history - even if they refuse to admit any culpability. It is less clear what role they played in the creation of the "tech bubble" of the 90's - yet doesn't take much to make an argument that the role was a major one. And now we find ourselves in the midst of the most "creative" period in monetary policy history - zero interest rates accompanied by quantitative easing parts 1 through "yet to be determined". Correct me if I am mistaken, but as far as I can tell, nothing even closely resembling current monetary policy has ever been attempted in our history.
As alluded to above, there is another striking coincidence with the elevated valuation levels in the past 20 years.......the "bubbles". We experienced the tech bubble of the 90's - creating historical gains over the course of a decade but ultimately bursting in quite ugly fashion between 2000-2003. Over the next 5 years we created a real estate bubble the likes of which we have never seen. That bubble ended with the "Great Recession" - with real estate imploding and taking stocks and the overall economy along for the ride. We are now 5 years into the "recovery" - spurred on by unprecedented Fed action as discussed above.......
At the risk of sounding like an old curmudgeon, I should also point out one final phenomenon that has taken shape over the past 20 years (or longer) - the level of consumption in this country (otherwise known as lack of savings). Yep, the "instant gratification" generation (mine, I guess) which has been followed by the "quicker than instant gratification" of today. I know anyone over the age of 60 reading this is pounding the table yelling "That's right - that's my kids!". Well, I would submit that it was YOUR generation that started this insanity - and we just took it to another level - but that is a conversation for another day. The fact of the matter is that we - consumers and government alike - have been spending money that we don't have for a very long time. In short, I believe that there is (and has been) "excess in the system". And under the laws of economics in a free-market society - excess must eventually be removed.
You by now have guessed where I am heading with this - although it's probably not the extreme that you are expecting. It is true, I simply do not trust the current environment. I do believe that valuations are stretched and have been for quite some time, and that ultimately we will experience a "reversion to the mean". I am very skeptical of the yet-to-be-determined outcome of this unprecedented monetary policy. Remember, one definition of "risk" is "uncertainty" - and I would submit that the results of something never before attempted qualifies under that definition! I do believe that excess must eventually be removed from the system, and am skeptical (yet hopeful) that it can be done in an orderly fashion. For all of those reasons, I do believe the current environment to be one where caution is prudent.
So, does this mean we are recommending to clients that they sell out of all of their stock positions and purchase ammo and gold? Hardly. There are two lessons easily learned from history that all investors (and their advisors) should heed. First, assets can stay overvalued for LONG periods of time (see: 1990s). The second and even more important lesson? I (and you, and the TV, etc) can be COMPLETELY wrong in my assessment of current valuations - have been before and will be again. As such, it would be completely irresponsible to make "all in" investment decisions based on an opinion - even when the opinion is supported by "legitimate analysis". The fact of the matter is that opinions - no matter how well founded or educated - can be dangerous. They make investing emotional - and we have learned by now that emotion is evil when it comes to your investments. So I will encourage anyone reading this - agree or disagree with anything written - to stick to a disciplined approach, and leave emotion-based opinions out of it!
One final note - this series has focused solely on stocks in terms of valuation. One can easily make the case that bonds are currently more overvalued than stocks - that is a whole separate discussion (a very prudent one at that). In fact, one might envision a scenario where bonds are the next bubble waiting to burst, taking stocks and the economy along with it. Please do not take that statement as a prediction - I don't make predictions. At the same time, we need to be aware that bonds and other fixed income instruments have their own inherent risks - and we have not seen rapidly rising interest rates in a very, very long time. Please always remember to pay close attention to your true tolerance for risk....
Disclosure time! The opinions expressed in this rant (of which there are many) are solely my own, are not intended to provide specific advice or recommendations to anyone or anything, and do not necessarily reflect those of LPL Financial. Furthermore, investing involves risk - including potential for loss of principal. As always, past performance is never a guarantee of future results. And one for the road - any indices discussed on here are unmanaged and may not be invested into directly.
As always and most important - to all of our clients - we can never thank you enough for your continued trust and confidence in Round Hill Wealth Management.
Thanks for listening -
Doug