Make no mistake: Stocks are expensive, with the companies in the S&P 500-index currently at 28 times trailing 12-month reported earnings, offering a dividend yield of just 1.3% and sporting a Shiller price-earnings ratio of 37. All three metrics suggest stocks are pricey by historical standards.
Meanwhile, with far less risk, investors can collect 4.5% in annual interest with 10-year Treasury notes and an inflation-adjusted 2.1% with 10-year inflation-indexed Treasurys. Alternatively, for those who favor cash investments, there’s Vanguard Federal Money Market Fund (symbol: VMFXX), with its 4.2% yield.
With stiff competition from conservative investments, and with all the talk of slower economic growth, you’d imagine that stocks would trade at lower valuations—or, at least, that would be my guess. So why are valuations so rich? Three possibilities:
- Investors are anticipating that corporate earnings will soar. Perhaps investors are, but S&P Global sure isn’t. The research firm behind the S&P 500 is forecasting as-reported earnings will climb 15% in 2025 and another 15% in 2026—healthy gains, but hardly the stuff of irrational exuberance.
- We’ve moved into an era where stocks have been repriced to permanently higher valuation levels. This might reflect the high growth rate of today’s mega-cap U.S. stocks, notably technology shares. Alternatively, it may be that investors are simply much more comfortable holding stocks than they were three or four decades ago. I say all this with trepidation given the infamous remark made by economist Irving Fisher just before the 1929 stock-market crash: “Stock prices have reached what looks like a permanently high plateau.”
- The valuation yardsticks we’re using don’t capture how valuable today’s companies are. For instance, because companies are using so much of their spare cash to buy back shares, they’re less focused on paying dividends, so it’s hardly surprising dividend yields are low by historical standards. Similarly, because today’s high-growth companies are rich in intellectual capital, they look far less appealing when their share prices are compared to traditional measures of corporate assets.
None of this is prompting me to make any portfolio changes. I long ago concluded that valuation measures were no predictor of short-term stock-market movements, and that my best bet was to buy, hold and look to the long term. Still, if the economy slowed sharply, I imagine today’s rich valuations mean share prices could suffer a steep decline.
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Thanks for the thought exercise Jonathon. IMO, Ignoring valuations would be to your portfolio like what ignoring your health would be to your duration & quality of life. In that context, the question really answers itself…
I’ve been “mostly” retired for 3 years now and plan to fully retire in a few more months. I’m a mostly defensive, buy & hold value & dividend yield investor with a heavy concentration in hard assets (infrastructure, commodities – ie energy & PM’s, and REITs/ R.E. News flash: most REITS are not historically expensive, valuation-wise, right now. In fact many high quality names (like ARE, AHH) are at historically exceptional discounts to their NAV’s.
I also like hi yielding preferred shares purchased below call value in certain very stable/ strong Mtg & Equity REITs, and investing in moderation in BDCs, CEFs, MLPs and even some CLO via ETFs.).. I only own one “Mag-7” stock (APPL), which I’ve held for over a decade, and I’ve never owned bitcoin, so I mostly missed the Covid explosion valuations of all the big tech/ high growth names. “Oh well !”
OTOH when the S&P plummeted for a few weeks > 4/2/25 my max portfolio drawdown before the subsequent (rapid) recovery was < 8%, when my relatives & friends who love AI and the big tech names were all pretty crestfallen. My portfolio value is now higher than it was on 4/1, despite net withdrawls since then for mortgage payments, home improvements, etc.
And, the high dividend yield aspect of my investing style reduces volatility quite a bit, and makes me fairly sanguine/ resilient whenever my portfolio does experience volatility. I suspect there’ll be much more volatility ahead for us all over the next few years…and disappointing 10-year returns from here especially for S&P 500 investors, for the reasons you described re: current valuations which are very high based on the Buffet yardstick and many other historical valuation measures.
I have a tax background so I’m careful to hold investments where those high dividends & MLP distributions yield are almost all tax deferred or tax free (w/ no UBTI). Quite a few K-1’s on our tax return, but like anything else – knowledge is acquirable and even complex topics are manageable…the fear of the task is typically much worse than the reality. Holding MLP’s in taxable brokerage accts is a very powerful retirement savings accumulation tool, IMO.
Sorry this went so long, but I wanted to explain why I’m not too worried about valuations at the moment, even though I completely agree that wide areas of the market (ie the S&P500, Nasdaq, & growth stocks generally) are probably overdue for a major drawdown when the next “risk off” wave arrives… perhaps triggered by a US recession, or maybe due to various other negative geopolitical/ macro factors that always seem to be on the horizon lately. Tariff’s, inflation, higher 10-30 Yr interest rates? (Etc!.)
So, I’m personally not overly “worried” about valuations today, per se, based on how I’ve positioned our portfolio ever since Covid. But I will never ignore valuations. in fact when the big drawdown finally does arrive, I plan to focus on valuations intently – to rebalance much of our current holdings allocations away from short term treasuries, money market funds & high yielding preferred shares, and into newly beaten-down equities that I view as too expensive to buy today, but which may then become too attractive valuation and/or yield-wise to ignore.
Stock valuations are high because they’ve been artificially boosted by the massive increase of the money supply by the Federal Reserve. This was started during the 2008 finical crisis and expanded during the pandemic.
buddy mine was in big/short bonds in the days of local banking…’a corp want to park 100 million bucks for a week, how can i squeeze parts of a basis point??’
he’d do work between banking hours in the morning–done early. plenty of time to think.
his observation was ‘money has to go somewhere…’..and i asked where and said ‘it varies…’
Steep decline equals rebalance. Otherwise, ride it out.
Permanently higher? Nothing is permanent.
Steep run-up might also suggest rebalancing. As Jonathan indicates, the market has been pricey for much of this year, including this last week. This might suggest some rebalancing for those whose equity allocation has risen above target levels or who feel uncomfortable with elevated valuation levels.
but the question w todays markets will be cash or bondy and if bondy then how short??
Thank you, Jonathan.
I’ll make a few observations. Yes, I do think stocks are pricey by historical standards. Such valuations do make me pause when I consider purchases. While dividend yields are low at just 1.3%, yields on treasuries and MM funds are higher and are acceptable. The dividend yield of the payers in our stock portfolio reflects recent changes and is “only” 1.41%. For cash, if I can beat inflation or the CPI then I am satisfied; they provide ballast and short-term stability. I accept that cash can be a drag on overall portfolio performance. I’ll let the stocks and any other investments do the heavy lifting.
Long term I prefer a portfolio with broad stock exposure, no matter what is currently in vogue. One analysis indicates that my “stock exposure is spread evenly across the market and includes a good mix of small, medium, and large companies, as well as a fairly even mix of conservatively priced value stocks and high-flying growth stocks.” It does include foreign stocks. For me, that is a portfolio which satisfies my preferences. Looking under the hood, our stock intersection indicates 7 companies exceeding 1% of our combined portfolios. My personal portfolio has 9 companies above 1% and the largest holding is 3.93%. It is not one of the “magnificent seven”. I do have an upper bound for the percentage of any one stock in my portfolio
When it comes to building my portfolio, I think “Do everything in moderation”.
My portfolio was about 70/30 stocks/bonds-cash. But as I approached true retirement, I reduced growth and shifted to 50/50. That change had nothing to do with current events. The equities sold were dictated by my desired allocation targets.
My 50/50 allocation is not cast in stone and I’d be okay with a 60/40 or whatever, but with a minimum cash cushion. Bengen, Morningstar analysis of portfolio performances and my personal experience and numbers indicates that my current allocation does not have to change. I’m retired, so I am of the opinion that holding cash, 5 years of spending or more (after other income) is probably prudent. That stimulated my change to 50/50 and has been my approach since the day my work-related income ceased.
I’ve been re-evaluating and this is because of recent changes to the SS benefits for my spouse. She has social security retirement benefits in her own record, but because of a pension it was assumed she would get little of that. It seems this is no longer accurate.
I think it is dangerous for investors such as myself to think of stock evaluations as being “permanently high”. Nor do I consider hunches to be a good investment strategy. If I make mistakes, and I do, then I prefer to err on the side of caution. So, while I consider myself to be a “buy and hold” investor, I don’t buy with the intent “to hold forever”. In fact, selling equities is something I prefer not to do, and in the last 10 years I only did so to fix my equity allocation or to get an individual stock to within an arbitrary upper bound. I do own a portfolio comprised of ETFs and individual stocks, rather than one solely of indexes. This allows me to further customize equity allocations, but I admit this isn’t for everyone and it may not beat any one index over periods of time.
Reduced dividends haven’t stimulated me to buy high dividend payers either, probably because I do want to own stocks that have growth potential and hybrid growth/dividend stocks tend to have lower dividends. However, those dividends have added to cash in my traditional IRA. I haven’t had to sell stocks to meet IRS RMD requirements.
I have not been rattled by political changes. Not in 2016, 2020 and not today. I think there are a lot of opportunities in the current market. Some companies have more attractive valuations, some dividend payers too.
Macro events may be worth keeping an eye on. I did make changes in 2007 in preparation for potential events. But I didn’t bail, I simply stopped adding to my stock portfolio. At that time, I was on the cusp of early retirement age and I became more cautious. Caution however doesn’t dictate significant changes to my portfolio and like Jonathan, at this time “None of this is prompting me to make any portfolio changes.” I haven’t sold anything since 2021 but I did add to equities on 11/22/2024.
If the economy slowed sharply I expect a decline in share prices and decrease in portfolio value. As a retiree, that’s my incentive to hold a cash buffer. However, I thought 2021 would be a high for my portfolio, if for no other reason than the shift to a 50/50 portfolio, the fact I’ve added nothing and the withdrawals I have taken annually since 2019. I checked the numbers and astonishingly the portfolios are 8.5% higher than they were on 12/31/2021.
I should probably frame it because yes, there will be a recession someday and a market correction.
That ‘someday’ is probably sooner than you think…
I was still relatively new to investing during the mid 1990s. The Dow was around 4000; I recall thinking that things were overpriced. Does anyone have a time machine I can borrow?
I’m glad you addressed this topic. I do think US stocks are overvalued today. Buffett appears to think so, given his pile of cash. The problem with an average small investor like myself emulating what he does doesn’t scale.
If I were decades younger, I’d keep my head down and just continue investing in a stock heavy portfolio. But now that I’m retired my burn rate, horizon, and desire for future real growth has led me to 50% Stocks/50% short and intermediate Treasurys and TIPS. Besides rebalancing, I’d consider increasing my stock allocation if and when prices came down from their lofty levels. But if they don’t I’m OK with that.
The word is out: you have to invest to get rich. Investing drives up share prices. More people are on the bandwagon than ever before and more joining all the time.
Ipso facto…
Many of the classic dividend growth stocks / dividend kings will provide 2-3% yields (with MO providing over 6%), and are experiencing capital appreciation as well, which is why the current yields are low. Think about it, the current yield is the current cash dividend/current price.
If you buy at $100/share, and the current yield is 1%, then if both the share price and dividend payments IN DOLLARS AND CENTS go up 10%, the current yield on any given day is 1%. When you come back 7 years later and look at the share price and it’s doubled, and your dividend has doubled, you are richer.
Getting caught up in current yield is a fool’s game. If Company XYZ increases their dividend payments by 10%, you got a 10% raise. People claw and battle at their jobs to get 5% raises, yet there are companies out there massively growing their dividends every year.
Since 2008, I’ve followed a dividend growth strategy and it’s been awesome, so I never worry about valuations. I just keep reinvesting dividends. If stocks crash in the short term, I win because I buy more shares with those increased dollars. If Company XYZ has increased dividends through the worst world events since 1960-70, I’m confident they will continue to do so.
Agree with your conclusion that valuation measures are no predictor of short-term stock-market movements. But what about the longer term, say 10 or 20 years. Do you think today’s high valuations make it unlikely that stock-market returns the next 10 years will be lower than average and that maybe it would be more prudent to put 10-year money into bonds rather than stocks (at least US stocks).
I’ve been assuming that U.S. stocks would have below-average returns for years, and I’ve been wrong. Fortunately, I didn’t act on my “hunch.” I’m not sure I’d allocate more to bonds, but I would hold a globally diversified stock portfolio and keep enough in conservative investments to cover at least five years of expected portfolio withdrawals.
Thanks Jonathan, that seems like the most prudent approach.