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Unanswerable

Jonathan Clements  |  March 8, 2017

“IF YOU DON’T MIND, I have a question for you,” wrote a former colleague. “Should folks be getting out of the stock market? This Trump bump seems like such a crazy bubble.”

Lots of folks are asking this question. How to respond? I fall back on three key points.

First, I believe U.S. stocks are expensive, while foreign stocks are cheap. But that doesn’t tell you anything about short-term performance and only a modest amount about long-run results. A Vanguard Group study found that price-earnings ratios (both the conventional and Shiller variety) were the biggest determinant of 10-year returns. But even then, P/Es explained just 40% of performance.

Second, by most measures, the U.S. stock market has been overvalued since 1990, and yet folks keep buying stocks. The market’s short-term performance is driven by news, and nosebleed valuations are not news.

Third, if we ask the wrong question, we’ll get an idiotic answer. Nobody should ever make an investment decision based on a market forecast, because nobody can predict the market’s short-term direction. Don’t ask, “Which way is the market headed?” Instead ask, “What are the consequences if stocks plummet?”

If you’re a 45-year-old who is saving for a retirement that’s two decades away, the consequences wouldn’t be particularly dire and, in fact, it could be helpful, because your monthly savings will buy shares at cheaper prices. But if you’re a parent with a stock-heavy 529 plan and college-bound teenagers, a big stock-market decline could be a disaster, which is why money you’ll need to spend within the next five years should be out of stocks and stashed in conservative investments.

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