Beyond Valuations

Adam M. Grossman

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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