In the April newsletter, we wrote an article titled The Truth About P/E Ratios. That article noted that the stock market is currently very richly valued when compared to its historical pricing, but also that market valuation is a notoriously fickle measurement tool when it comes to predicting what direction the market will head next. Sure stocks may be expensive today, but they can always get more expensive tomorrow.
Nonetheless, SMI has ramped up its discussion of market valuations in recent months due to another factor that has a much better track record of indicating the market's future direction. That factor is monetary policy — specifically what the Federal Reserve is doing with interest rates. It's been our hypothesis for several years now that the unprecedented actions of the Fed in the early part of this decade would push this bull market farther and longer than almost anyone could imagine. That part has proven true already. But we've also maintained for years that the time to start getting nervous about the market faltering would be when interest rates started rising again. It took a long time, but we're finally there. The first rate hike came in December 2015, the second in December 2016, and the third last month in March. More are planned for this year.
That doesn't mean anything the stock market's direction is going to change immediately. But it does heighten our awareness of the downside risks posed by today's lofty valuations.
As a follow-up to our P/E piece last month, I want to bring to your attention a recent article from John Mauldin. In Stock Market Valuations and Hamburgers, Mauldin takes a deep dive into a number of other market valuation metrics. It's a powerful presentation — going through them one by one and seeing just how many different valuations metrics score this market as richly overvalued based on historical readings.
There are a number of great indicators and charts in the article, and I'm tempted to excerpt them all here, but I'll refrain. That said, I encourage you to at least browse the report and look at the charts even if you don't read the whole thing. It's sobering to see all of these different measures pointing to the same conclusion: risk is extremely high due to today's valuations being comparable to those prior to the 1929 crash. The only period with more extreme valuations was the end of the dot-com bubble, circa 1999.
Toward the end of the report, Mauldin notes that if we don't have a recession by 2020, "we will have lived through the first decade in 120 years without one." The implications of this are significant. Bear markets that are independent of economic recessions tend to be quickly reversed. But those attached to recessions tend to be doozies.
The good news? There's really nothing out there indicating a recession is imminent or likely in the near term (i.e., this year).
It's worth noting that Mauldin is another (like us) who believe one implication of what we're witnessing in the markets right now is "peak indexing" — the moment in time when all the factors are aligned to best make the case to investors that passive indexing is the best approach. The recent track records, the current market dynamics...everything is pointing to indexing being superior to active management right now, and investors are buying it, leaving active management in droves in favor of index funds. He, like us, believes this story is going to end in tears for those indexers when the market finally turns down and the next bear market takes hold.
To clarify (because some readers are always confused when we write things like this), we're not trying to convince anyone to change their investing plan based on the overvalued conditions being discussed here. However, there's a natural tendency over the course of a long bull market for investors to become increasingly aggressive the longer the bull market lasts. Generally speaking, investors stay way too conservative for way too long early in a bull market, then at the point when they should rightfully be getting concerned about the market's future risk, they get overconfident and are way too aggressively exposed when the next bear market arrives. Instead of being aggressive early in the bull market and conservative late, they do the opposite and pay dearly.
The goal of articles like these is simply to help you gauge, as best as we can, where we likely are in the market cycle. We're trying to be a bit of a counter-weight to the natural tendency to be aggressive late in the bull market when gains seem so easy and everyone is bullish. Just as we were a counter-weight in the other direction back in the early days of this bull market when everyone was fearfully waiting for the other shoe to drop. If it feels like we're always encouraging you to be cautious when you feel confident and confident when you feel afraid, you're catching on to the pattern!
So don't rush out and make big changes thinking we're saying the next bear market is beginning. Valuations don't tell us much about timing, and we really have no historical guide on the monetary policy front to know what's likely to happen when the Fed raises rates back to "normal" from zero (because the Fed has never pushed rates to zero before!). The next bear market could be beginning — or it could still be a ways off in the future.
But do give serious thought to how you're going to handle your portfolio during the next bear market. And whether your present mix of strategies (and stock/bond allocations) are appropriate for the market turn and next bear market. Those are wholly appropriate questions to be asking right now, and if the answers dictate you making some adjustments, you can prayerfully consider those now in an environment that isn't already charged with the fear of steep market declines.