Investing in its most basic form can be defined as purchasing an asset with the expectation that future cash flows (income and/or proceeds from a future sale) will result in a profit. This simplistic definition of investing helps highlight the importance of the price paid for an investment. The higher the price paid now, the less likely expected future cash flows will produce a profit.

In a world of passive investments, it is very easy for investors to disassociate the price of the index from the expected cash flows of the underlying companies. When investors disassociate these two components of return, they shift from investing to speculating. Investors consider price. Speculators pay any price in hopes that something extraordinary will happen in the future. This leads to the question above: “Buy at any price?”

The S&P 500 Index, as measured by Price-to-Revenue ratios, has never been more expensive (see chart below). This chart shows that the price of the underlying companies in the S&P 500 Index has risen at a pace that far exceeds the increase in revenues.

The late 1990s tech boom saw an extreme rise in the price of technology and telecom stocks, leaving other stock sectors cheap. However, the recent rally in stock prices has been broad-based.

The chart below breaks down the stocks in the S&P 500 Index into tenths (meaning 10% increments) from the highest valued 10% to the lowest valued 10%. Notice how the spike in the late 1990s was confined to the top decile of stocks, meaning the most expensive 10% of the market was very expensive relative to history, but the other deciles were much more reasonably priced. In contrast, currently every decile of the S&P 500 is expensive relative to historical Price-to-Revenue metrics.

 

 

Many investors justify current stock prices as being reasonable not by comparing prices to history, but by comparing stocks to bonds. In other words, the argument being made by some is that stock prices are reasonable when compared to bond prices, even though both are extremely expensive on a historical basis. That does not mean the stock market cannot or will not go higher from here. Japan provides a good historical perspective.

In the late 1980s, the Japanese stock market (Nikkei Index) reached high valuation levels comparable to the current valuation for the S&P 500 Index. Sure enough, Japanese investors became speculators and the Nikkei Index proceeded to double in price! Those who missed out on the gains were surely kicking themselves.

However, the laws of financial gravity eventually returned. The historical relationship between price and future cash flows was restored. Over the next 20 years, the Nikkei Index dropped until reaching an eventual bottom, down 81.9%! That would equate to a 63.8% drop from where the S&P 500 sits today.

The “buy the dip” mentality that exists today has proved to be a surefire way to make money. Leading up to 1990 in Japan, that strategy would have worked well too. Take a look at the Nikkei chart that follows and imagine how buying each dip would have fared from 1990 onwards.

 

Tokyo Stock Exchange (Nikkei 225)

 

Currently, the rationale that low interest rates justify high U.S. stock prices somehow does not exist overseas. Neither the developed markets in Europe or Japan nor the emerging markets trade at valuations comparable to the U.S. market (S&P 500 Index) despite low interest rates around the world.

Disciplined investors take a long-term view and try to ignore short-term distractions. As the Japanese experience (and many other speculative episodes) demonstrate, markets have a way of lulling investors into a sense of complacency because the rising risk occurred over time. After a while, many start to believe unsustainable increases can go on indefinitely and conclude that the real risk is not participating. Throughout history, investors that bought into overvalued markets paid a dear price – maybe not at first, but eventually.

We encourage recent retirees and those approaching retirement to review their portfolios.  Large drawdowns prior to or early in retirement can result in a significant reduction in long-term financial security. There are common-sense steps investors can take to mitigate the risk associated with elevated valuations in U.S. stocks and bonds.