WHERE DOES THE STOCK market stand? After 2022’s decline, is it now fairly valued—or still overvalued?
When I think about questions like this, I’m reminded of an opinion piece written by Robert Shiller a few years back. By way of background, Shiller is a professor at Yale University and a Nobel Prize recipient. Along with a colleague, he created one of the more well-known and well-regarded measures of market valuation: the cyclically adjusted price-earnings ratio (CAPE).
Unlike a typical price-earnings ratio, which uses only short-term earnings numbers, the CAPE includes 10 years of historical data. Because of that, the CAPE ratio is viewed as a more accurate measure of market valuation. For that reason—and because Shiller has an above-average track record in making market forecasts—he’s seen as an informed voice on the stock market.
Still, even Shiller recognizes that there’s more than one way to look at the market’s valuation. Two years ago, in the midst of a market rally, Shiller made this statement: “The stock market is already quite expensive.” Then he added: “But it is also true that stock prices are fairly reasonable right now.” Why the seeming inconsistency? It depends on the yardstick, Shiller said.
At the time, in 2021, the market was indeed overvalued according to the CAPE ratio. But using a different measure he’d developed—the Excess CAPE Ratio—stock prices weren’t unreasonable. Shiller’s conclusion: Market valuation is a matter of perspective.
CAPE ratios are just two of the measures available to evaluate the market. In a recent article, The Wall Street Journal looked at several others and reached the same conclusion: It found challenges with each of them. Traditional price-earnings ratios, for example, can be biased when they’re based on Wall Street analysts’ expectations, which tend to be optimistic. They’re also susceptible to public companies’ accounting decisions, which can be creative at times.
Even Warren Buffett’s preferred measure—comparing the total value of the U.S. stock market to the total output of the economy (GDP)—has a weakness: More companies today are choosing to stay private, and that’s distorted the data.
Bottom line: Market valuation is, to a great degree, in the eye of the beholder. More important, none of these measures has terribly strong predictive powers. Look at CAPE readings through the 1990s, for example, and you’ll see that the market looked expensive for many years in a row, and yet it continued to rise. That made it an imperfect guide through that tricky period. Shiller himself acknowledges that, “I believe [the CAPE ratio] is an excellent tool for analyzing price levels, but its forecasting ability is limited.”
The good news: There’s an entirely different and, I think, more practical way to look at the stock market. I would instead rely on these four principles:
Avoid predictions. As Shiller himself says, it’s very difficult to forecast where the market is going in the short term. Valuation metrics are of little help. What we do know, however, is that periodic market downturns are inevitable. We just don’t know when they’ll happen. I suggest that investors avoid even attempting market predictions. Instead, to protect yourself from the market’s inevitable downturns, simply structure your portfolio so it’s prepared to weather a downturn whenever it arrives.
Consider submergence. How can you prepare your portfolio for a potential downturn? A recent paper titled “Submergence = Drawdown + Recovery” offers a helpful perspective. The authors use the term “submergence” as a measure of market downturns. It answers this question: When the market goes through a downturn, how long does it take to recover to its prior high-water mark?
This, in my view, is the critical factor, especially for those in retirement. If you’re taking withdrawals from your portfolio, a key pitfall is sequence-of-returns risk. If an investor is selling stocks while they’re underwater, it can jeopardize the longevity of that portfolio. For that reason, it’s important for investors to have a grasp of past submergences—their frequency, depth and duration.
What does history tell us? When the market dropped in early 2000, it took between five and six years to recover to its prior high. By the end of 2005, an investor would have been back to even. Similarly, when the market dropped in the fall of 2007, it continued to decline through 2008 and into early 2009. It then began a recovery, and an investor would have been back to even in a little less than five years—by the middle of 2012. In both episodes, the market dropped about 50%. In situations like that, it would have been critical to avoid selling stocks until the market had recovered.
The upshot: I recommend that retirees prepare their portfolios for a submergence of at least five years. What does that mean in terms of asset allocation? If you’re using the 4% rule for portfolio withdrawals, you would want to hold 20% (4% x five years) in conservative investments. I see that as a minimum. To be on the safe side, you might extend that to seven years, for three reasons: because a future submergence might be longer, because an unexpected expense might come up and simply for peace of mind.
Diversify. Diversification is the first rule of investing, but how can you use it to protect yourself from submergences? Normally, diversification is measured by looking at correlations between assets. If one asset zigs when another zags, they’re seen as good complements in a portfolio. The authors of the submergence paper point out, however, that correlation numbers can be misleading.
Consider indexes of short- and intermediate-term bonds. They each have very low correlations to stocks—between 0 and 0.3. By this measure, they both look like excellent diversifiers. But anyone who lived through 2022 now knows that a low correlation doesn’t mean no correlation. Last year, both stocks and bonds dropped, but intermediate-term bonds dropped far more than their short-term cousins.
The implication: To effectively protect your portfolio from multi-year submergences, it’s important to look not just at correlations but also at the behavior of each asset during past submergences. Based on the data, I see short-term bonds as the most effective way to offset the risk of a stock market submergence. Does that mean you should never own intermediate-term bonds? They’re okay. I’d just be sure they’re only a minority of your bonds.
If you’re buying. What if you’re in your working years and still adding to your portfolio? How should you think about submergences? I see this as much less of a concern. To be sure, the market could decline the day after you add new dollars to your account. But if you’re saving for the long term, and the dollars you invest today won’t be the only dollars you’ll ever invest, I wouldn’t worry too much about where the market stands today and what it might do in the short term.
Historically, the stock market has risen in about 75% of annual periods. If you’re investing a particularly large sum—more than, say, 5% of your net worth—you might employ dollar-cost averaging. Otherwise, I wouldn’t let any measure of stock market valuation hold you back from putting your investment dollars to work.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
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A decent empirical measure that can be used to forecast forward stock returns has been the advent of negative double-digit years produced by the S&P (500) index. Since 1931, after the advent of negative double-digit years produced by the S&P 500 ( most recent 2022 ), forward 5 & 20 year stock returns, especially “value” stocks, were substantial Table 1 https://tinyurl.com/4x3wn7sd . And returns were decent even after having to endure an “additional” year (multi-year submergences) of double-digit decline ( ie. 1931, 1974, & 2002 ) Table 2.
This measure doesn’t attempt to tell us if a market is overvalued ( heck, we’re not going to sell “at a top” anyway ), yet provides a perspective on the futility of panic selling after the market has already declined, and the resulting gains that an investor will miss if they are fearful and impatient.
“…to protect yourself from the market’s inevitable downturns, simply structure your portfolio so it’s prepared to weather a downturn whenever it arrives…”
Good advice, but is it so “simple” to do?
“If you’re using the 4% rule for portfolio withdrawals, you would want to hold 20% (4% x five years) in conservative investments.” This doesn’t make sense to me. The 4% rule is not a percentage of portfolio withdrawal rule, and so one may quickly end up drawing well over 4% of the portfolio each year after only a few years in retirement. If inflation has put retirement withdrawals at say 5% of the portfolio, the 20% only lasts 4 years; and so on as inflation puts increasing pressure on the portfolio over time. By the time the 4% rule resulted in a withdrawal of 6% of the portfolio, are you saying you would shift to 30% in conservative investments, and so on until the portfolio is eventually 100% conservative investments?
I don’t see much harm in thinking of bonds as a set number of years of expenses, but the 4% rule completely disregards the portfolio balance after the first annual withdrawal, so combining these concepts seems to be erroneous.
Five to seven years of portfolio withdraws (20 to 28% of your portfolio) in short term bonds seems excessive to me. In most instances you will be substantially reducing your overall portfolio returns needlessly. Best not to be too myopic regarding bear markets. Yes, you need to be prepared for bear markets, but if you allocate too much capital to protecting against such markets you will have permanently reduced your opportunity to grow your capital in the stock market. I think what you fail to consider is the opportunity cost of holding short-term bonds.
If VMFXX is paying 4.78% and the best of those three funds is paying 4.17% why not just in the MM for now?
Hi Rick – I’ll piggyback on Jonathan’s comment: Cash and bonds are similar but do differ. The only upside on cash is the interest that it pays. Bonds can potentially gain in value–though they can also lose, as we all saw in 2022. For that reason, I come back to the fundamental rule of investing: diversification. Because they are different in this way, cash and bonds each have a place in investors’ portfolios.
I started investing in 1978 with my first stock purchase and over the years have basically been 100% stock or stock mutual funds. Over the last 10 years I have expanded to where today I am about 75% stock, mutual funds, ETFs and CEFs with about 15% bonds and 10% MM. Being that I am 73 and my wife is 77 that may be to heavy on the stock side but I tend to lose money on the bond side and make money on the stock side. I understand it was just the market and not my skill, and I follow Bogle’s “time in the market versus timing the market” in how I approach investing. Always read Jonathan’s and your write ups and responses and it is always interesting and instructional. Keep up the good work.
I assume you’re referring to Adam’s comment below. If and when short-term interest rates drop, they could drop quickly — and today’s handsome yields on cash investments would also quickly disappear. Meanwhile, those who own bonds will likely see their yields drop more slowly, but there will be some drop — which will push the price of these bonds higher. In other words, despite their lower current yields, the total return from here on short- and intermediate-term bonds could be higher than that on cash investments.
If it turns out that interest rates stay high for several years, the market will eventually decline. Valuations are too high if you can get 5% risk-free from short and medium term Treasuries. But the market appears to believe interest rates will go down soon.
Another great article.
If you are living in retirement (IRA and SS only) where would you put the 7 years of a conservative investments as you described in the above article?
Hi Paul – I agree with David and Jonathan. I’ll often build a bond allocation with these three components:
60% VGSH – short-term Treasurys
20% VGIT – intermediate-term Treasurys
20% VTIP – short-term TIPS
In other words, 80% of the bond allocation would be short-term.
A few variations to consider: For tax-efficiency, I’d hold the TIPS only in retirement accounts (because they generate phantom income), and you might substitute some of the Treasurys with munis in taxable accounts, if you’re in a high tax bracket.
This isn’t written in stone. The most important principles, IMO, are to stay predominantly short-term and to stick with government bonds.
I tested this 60/20/20 bond allocation in portfolio visualizer over 10 years (1/2013-4/2023), but found a simple alternative would be 45% VGIT and 55% Money Market/T-Bills (CASHX in portfolio visualizer). This has the same max drawdown, but with zero stock market correlation, so pairs better with stocks than your suggested bond portfolio. I’ve spent many weeks testing bond allocations, and have not found any where adding short term bonds improved the outcome. When it comes to nominal Treasury bond holdings, the only thing that seems to matter is overall duration. With a mix of Intermediates and Money Market, you can choose any duration you want, by simply adjusting the split between the two.
Adding in TIPS is interesting in theory, but the improvement TIPS provided in 2021 was erased by mid 2022, so I’m still undecided on if TIPS have enough long term value to warrant the increase in portfolio complexity.
Cash, short-term Treasuries (VGSH) and short-term TIPS (VTIP) are worth a look.
Yes, that’s where I’d look.
Adam, great article. Thanks for the link to the article on submergence. I look forward to reading it.
A Humble approach may be always investing new money when you have it but leaning harder into the stock indexes in your portfolio when CAPE or *trailing* PE is at or below historical average (and you don’t badly skew your written allocation targets).
Adam, thanks for another interesting article with clear, useful advice.