Stock Valuations Are High… But What’s Next?

The most common questions I hear from clients these days are, “Isn’t the stock market ridiculously overvalued?” or “Are we going to have another crash?”

Many of these folks have seen their portfolios soar in value since 2009 but now worry about whether stocks can still go higher or whether this is a good time to book some profits. Investors are also not quite sure where to invest new money with many good stocks and major market indices at or near all-time highs. The Nasdaq just touched a 14-year high and the S&P 500 is also close to an all-time high.

With all the bullishness in the market, Nobel Prize winning economist and Yale professor Robert Shiller wrote a piece just last week where he essentially says stocks are over-valued by historical measures. Shiller says his CAPE ratio is now above 25 and “hovering at a worrisome level”.

CAPE stands for Cyclically Adjusted Price-to-Earnings; it’s a ratio Shiller developed with fellow-economist and Harvard professor John Campbell in 1988 using price and earnings-per-share data from S&P 500 companies going back to 1871.

The CAPE ratio divides a stock’s current price by the average inflation-adjusted earnings-per-share over the past ten years. It smooths out earnings over a 10-year timeframe to remove business-cycle volatility and is useful in comparing valuations over long horizons.

CAPE essentially builds upon an idea first developed by Benjamin Graham and David Dodd; Warren Buffett’s investment gurus. So CAPE rests on some pretty solid investment thinking.

Shiller says his CAPE ratio is now above 25, up from about 23 a year ago, and far above its 20th-century average of 15.21. And he says since 1881, CAPE has surpassed the 25 level in only three periods: 1929, 1999 and 2007. Do those years ring a bell? Yup, after each of those periods, there was a sizable drop in the market, as most of us know.

So Shiller says, this CAPE reading above 25 should, at the very least, prompt some serious questions about valuation and where we go from here. He says CAPE was not developed to time buy or sell decisions, so a value above 25 does not mean a fall is imminent, and says markets could well continue at current or higher valuations for several more years.

But Shiller cautions us that over the past 100 years, CAPE has always reverted to its historical mean and periods of high CAPE have inevitably been followed by stock-price declines.

Shiller cites more data on why stocks could be in for a correction. In 1989, Shiller started surveying investors on whether stocks were over-valued, under-valued or fairly valued and created a Valuation Confidence Index to gauge market perceptions on valuation. If most investors thought stocks were over-valued, they’d have little confidence in buying them and the Confidence Index would be low. But if most investors thought stocks were undervalued, they’d have higher confidence in putting their money into the market and the Confidence Index would be high.

What Shiller then found was that when CAPE hit a high, the Valuation Confidence Index hit a low and stocks eventually corrected.

Shiller’s Confidence Index is now at its lowest level since the year 2000. This low Confidence Index reading tells him that investors are beginning to worry and a market correction could be imminent.

Shiller also doesn’t see any solid fundamental justification for high stock prices – and he attributes the current market high to the vagaries of investor psyche and irrational exuberance, which he thinks will ultimately reverse.

On the flip side, other market watchers think Shiller’s warnings are unwarranted and that stocks have much further to run. For example, Jack Boroudjian of Index Financial Partners thinks Shiller’s CAPE is significantly flawed because it looks back 10 years whereas stock prices reflect future earnings potential… and, Jack says, on forward earnings, the S&P 500 has a P/E ratio of about 16 which is well in-line with historical levels and nothing to be worried about.

Heavyweights like Warren Buffett have also chimed in on Jack’s side, with Buffett saying, a few months back, that stocks were not “overpriced” or due for a correction. The bulls also say there’s nothing in the macro data that would put stocks on a downward trajectory just yet even though valuations are higher than normal.

So some say up, some say down and virtually no one thinks the market will stay flat going forward. But what they all agree on is that it’s hard to predict how much longer stocks could continue to rise or when the correction might come. At times like these, I think it’s prudent to consider hedging strategies that protect your portfolio on the downside but continue to give you upside should shares continue higher.

Speak to your advisor about simple hedging strategies such as buying at-the-money puts with long-expiration dates because everyone agrees it’s hard to predict the timing of a reversal. It could be a month from now, it could be two years from now or more, that’s why you’d want the sort of insurance that a put option can give you.

Also, look for strategies that use tools to determine if stocks are in a hostile environment or a healthy environment. A hostile environment for stocks may include rising inflation, rising interest rates, serious geo-political concerns and signs of a fragile market. None of these tools are perfect, but they may protect you from a serious decline in your stock portfolio.

I also don’t want you to cash out and sit on large capital gains and owe taxes. I’d rather see you stay invested in the market, just with protection. If you strongly feel folks like Shiller are right and you’re nervous about staying in, consider talking small profits as the market climbs and sitting in cash for a while.

Currently Buffett has $50 billion in cash as he is waiting for his next big acquisition. There is nothing wrong with cash as long as you think of it as a temporary solution rather than an investment all by itself.

If you’re young and have a long time until you will need this money, forget all I have said and just keep investing on a regular basis. Markets will rise, markets will fall, but over the long term history has shown that stocks will beat inflation and should create some real wealth for you.

Do what Shiller says: ask some serious questions about valuation and talk to your advisor about where to go from here.