Fear of Heights

Adam M. Grossman

THE S&P 500 INDEX just hit a new all-time high, topping 5,000 for the first time. Is it now too high? For investors concerned about market risk, this is an important question. But it isn’t an easy one to answer.

For starters, there’s no single definition of “too high.” Consider the price-to-earnings (P/E) ratio, the most common measure of market valuation. By this metric, the market does indeed look pricey. The P/E of the S&P 500 stands just a hair below 20 based on expected 12-month earnings—far above its 40-year average of 15.6. Should that concern us?

The reality: The economy today isn’t the same as it was 30 or 40 years ago, and that has implications for valuation ratios. Specifically, the companies that now dominate the market have very different financial profiles.

The five largest S&P 500 companies today are Apple, Microsoft, Amazon, Nvidia and Alphabet (parent of Google). Together, these five companies account for more than 20% of the S&P 500’s total value. From a financial perspective, what makes them notable is that, over the past 10 years, their profits have grown at an average 25% per year—a remarkable pace for companies of their size.

We can contrast these companies with the market leaders of the past. In 2001, the five largest companies in the S&P were General Electric, Microsoft, Pfizer, Citigroup and Wal-Mart. Aside from Microsoft, the market leaders consisted of an industrial company, a pharmaceutical manufacturer, a bank and a retailer. While they were all large companies, the profitability of these kinds of businesses doesn’t compare to that of the tech companies now driving the market. That’s why many argue that today’s higher valuations are justified.

Another reason to see today’s market as fairly valued: Traditional valuation ratios paint a distorted picture. According to an analysis by JP Morgan, as of Jan. 1, the average P/E of the 10 largest companies in the S&P was a lofty 27. By contrast, the average valuation of the other 490 companies was just 17—not far above the index’s long-term average. Through this lens, the market today isn’t more expensive than it’s been in the past. It’s just that the unusual group of companies that sit atop the market are much larger, more profitable and faster-growing than the rest, and that makes the market appear more expensive than it really is.

To be sure, some investors remain unconvinced. They argue that international markets offer far better value. Indeed, at year-end 2023, the U.S. stock market was among the world’s most expensive. That’s true—mathematically—but boosters of U.S. stocks are quick to point out why that’s the case: Nowhere else in the world is there a group of companies that matches the tech leaders in the U.S.

Yes, there’s Alibaba in China, Samsung in Korea, TSMC in Taiwan and others. But no international market has the sort of concentration of fast-growing technology companies that the U.S. has. That’s another reason the market here may not be as expensive as it seems.

So far, we’ve only looked at the market through the lens of the P/E ratio, but it isn’t the only yardstick. Yale University economist Robert Shiller is co-creator of an alternate barometer known as the Shiller P/E. During the 2021 rally, he made this statement: “The stock market is already quite expensive. But it is also true that stock prices are fairly reasonable right now.” Shiller explained the seeming inconsistency by arguing that there is more than one way to assess the market. Through one lens, it might appear expensive. But through another, it might appear reasonably priced.

For the past several years, in fact, Shiller has advocated a successor to his original P/E. He calls the new one the excess CAPE ratio. This new metric looks at stocks relative to bonds, rather than comparing stocks to their own historical average. The upshot: It’s another example of how market valuation is in the eye of the beholder.

Without the benefit of hindsight, of course, we can’t know whether the market today is actually too high. How can investors manage that uncertainty? I have three suggestions:

Ignore the market. Since we can’t be sure where it’s headed, investors’ best bet may be to simply ignore where the market stands at any given time. In a recent article, researcher Nick Maggiulli asked this question: Historically, if investors had put money into the market on days when it was at all-time highs, how would those investments have done relative to investments made on all other days? His conclusion: It depends.

Over one-year periods, investing at all-time highs yielded better results than investing on all other days, because the market exhibits momentum. But over five- and 10-year periods, returns were lower for investors who put money to work at all-time highs. That makes intuitive sense, but there’s an important caveat: Returns were still positive in all cases.

In other words, we’d all prefer to invest when the market’s cheap, but investors were still better off putting money into the market at all-time highs than not at all. The lesson: Investors who wait on the sidelines in the hope of earning better returns may miss out on receiving any returns.

Ignore commentators. I often recommend tuning out the advice of market experts. That’s because the investment world is full of commentators who became famous with one—but only one—successful prediction. These include Michael Burry, made famous by The Big Short, who in recent years has predicted a series of crashes that haven’t materialized.

Robert Shiller, who himself has an above-average track record as a forecaster, acknowledges how difficult it is. Referring to his own P/E measure, he wrote in 2014 that, “The ratio has been a very imprecise timing indicator.” The implication: Market measures are interesting, but we shouldn’t see them as anything more than that.

Diversify. While I’m not worried about the U.S. stock market, no one should ever be too confident. To appreciate that, look no further than Japan’s Nikkei 225 index. In December 1989, it closed at 38,957. Where is it today? At 36,897—still below where it stood more than 34 years ago. The performance has been horrendous.

While Japan has faced some unique challenges, including deflation and stagnant population growth, we can’t ignore this example. Fortunately, there’s a simple solution: diversifying your portfolio internationally. That way, if a problem does materialize in the U.S., you’ll have time to wait it out. Some investors recommend holding as much as 50% of your stock portfolio outside the U.S. I prefer something closer to 20%. But the important thing is to simply have some exposure.

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 X (Twitter) @AdamMGrossman and check out his earlier articles.

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