Special Edition

Jonathan Clements  |  January 20, 2016

WELCOME TO THIS special edition of my newsletter. I hadn’t planned to put out another of these free newsletters until March. But with the S&P 500-stock index down 13% from its May 2015 high, it seems like an apt time to address market valuations and discuss what folks ought to do with their portfolio.

What’s Happening

Stocks started 2016 with a thud—and there’s been almost nowhere to hide. Whether you look at growth or value stocks, large companies or small companies, U.S. or foreign, the pain has been meted out pretty much equally, with most parts of the global stock market down roughly 10% so far this year. The pundits and the media have fingered all manner of possible suspects, including North Korea’s purported hydrogen bomb, plunging oil prices, China’s slowing growth and Middle East tension.

But the overriding concern is a possible economic slowdown and the impact on corporate earnings growth. Investors are trying to figure out what’s happening with the real economy, and the market craziness will likely continue until the picture gets clearer.

Some of my email correspondents have argued that we’re “overdue” for a market decline. This is the Victorian morality school of stock-market forecasting, where good times inevitably lead to bad hangovers. But it isn’t clear that the times have been all that good. Yes, the S&P 500 has gained a cumulative 175% since March 2009—but we’re up just 22% from March 2000, a notably modest reward for those who stuck with stocks for the past 16 years.

It won’t be long before pundits are comparing 2000-16 to 1966-82, a wretched 16-year period that saw the Dow Jones Industrial Average lose a cumulative 22%. In truth, the two periods are hardly comparable. Not only did stocks fare worse over the 1966-82 stretch, but also inflation was far higher, so real returns were truly awful. More important, by 1982, stocks were at bargain levels. It would be tough to make that argument today.

Where Valuations Stand

For a quick look at valuations, I head to, a site I probably visit half-a-dozen times each day. Under the “U.S. Stocks” tab, look for the link to “P/Es and Yields on Major Indexes.” As of Friday, the S&P 500 stocks were trading at a lofty 21 times trailing 12-month reported earnings, versus 18.8 a year earlier.

Surprised? Share prices may be falling, but corporate earnings have been falling faster, so price-earnings (P/E) ratios have headed higher. If we are in the midst of an economic slowdown, there’s a good chance earnings will slip further, so P/E ratios based on reported earnings could turn out to be a deceptive indicator of the market’s value.

Dividend yields may prove to be a better guide. Today, the S&P 500 is yielding 2.3%, versus 2% a year ago. While dividends are more stable than earnings, they too could get cut if there’s an economic downturn, which would make judging valuations even trickier.

That brings us to a second source of valuation data. You might call up the spreadsheet housed on Yale University professor Robert Shiller’s online data page. Click on the third link, which is labeled “U.S. Stock Markets 1871-Present and CAPE Ratio.” The cyclically adjusted price earnings ratio, or CAPE, was developed by Shiller and another economist, John Campbell. Often referred to as the Shiller P/E, it can be a more reliable guide to stock-market valuations, because it compares current share prices to average inflation-adjusted earnings for the past 10 years, thus smoothing out the impact of short-term changes in corporate profits.

Currently, the S&P 500’s Shiller P/E is at 23.6, versus a 50-year average of 19.7. What would it take to get back to average historical valuations? We would need the S&P 500, which closed today at 1859, to fall to around 1550. That would put the index 17% below today’s level and 27% below its May 2015 peak. I’m not predicting we’ll get that sort of decline. But it does tell you that U.S. stocks aren’t exactly cheap.

What to Do

Let’s start with the obvious: None of us has any control over the direction of stock prices or any real insight into where shares are headed next. The market will do as it pleases.

We do, however, have two considerable advantages. First, we control how we react to the market’s turmoil. We can opt to buy, sell or—and this is often the sensible choice—do nothing. Second, our time horizon is far different from that of the traders, stock analysts and money managers who drive the stock market’s daily performance. They’re worried about results over the next 12 months, because that affects their compensation. You and I should be worried about the market’s performance over the next few decades, because that’s what matters to our financial future. Five years from now, today’s bout of market indigestion will likely be long forgotten.

My advice: Calculate your current mix of stocks, bonds, cash investments and alternative investments, and compare it to your target portfolio weights. If you discover you’re taking more risk than you intended, this isn’t a good time to be selling stocks. Still, you might take that step if you’re truly uncomfortable with your portfolio’s risk level.

For the rest of us, this is a time to carry on as usual. If you regularly invest part of your paycheck in the stock market, you should keep making those investments, and feel mildly pleased that you’re buying at slightly lower prices.

If the slide continues, consider rebalancing back to your target portfolio percentages for stocks, bonds and other investments. But I wouldn’t be in a big hurry. That might sound like market-timing, but it’s more a matter of valuations. If the market rallies from here, you shouldn’t feel like you missed out on some great buying opportunity, because—from current valuation levels—returns are likely to be modest. My best guess (as always, the emphasis is on the word “guess”) is that a globally diversified stock portfolio will return 6% a year over the next decade, while inflation runs at 2%. That 6% is before subtracting out investment costs and taxes.

When I get around to rebalancing, I’ll probably tweak my overall investment mix slightly, as I continue to cut back my allocation to U.S. stocks and boost my exposure to both developed foreign markets and emerging markets. In the past, I have kept about a third of my stock portfolio in foreign markets. Lately, I’ve been increasing that sum and am now aiming to keep closer to 40% abroad, partly for the added diversification, partly because I hope to enjoy a slight tailwind as battered foreign currencies bounce back, and partly because foreign markets are better value. Check out As you’ll see, U.S. stocks are among the world’s most expensive, while a variety of smaller European markets and emerging markets look considerable cheaper.

In the past, when stocks have fallen sharply, I have occasionally over-weighted stocks. If the S&P 500 got below 1550, which means the Shiller P/E was below its 50-year average, I would probably boost stocks from 70% of my portfolio to 75%.  At that level, I would deem stocks to be attractive. To be sure, they wouldn’t be a screaming bargain—but that may be too much to hope for: In a world where inflation and interest rates are so low, and there’s an abundance of capital sloshing around the globe in search of investment opportunities, I doubt we’ll see bargains that scream any time soon.

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