One of the biggest questions facing U.S. stock investors going into 2022 isn’t about inflation or economic growth or even the COVID-19 pandemic. It’s about whether the U.S. stock market can maintain its historically high valuation. While by most valuation methods, U.S. stock prices look to be pricey, they seem to be unstoppable – rising on good, bad or no news. With this, one may ask, “Do valuations still matter?”  and “What do valuations say about the market today?”

To help me answer these questions, during one of our live Deconstructing Alpha podcast episodes, I interviewed Frontier’s very own Founder, Gary Miller, CFA.

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What is the most popular measure of valuations? And what does it say about the market today?

Today, the most popular measure of valuations is the CAPE (cyclically adjusted price-to-earnings) ratio – or what is also known as the Shiller P/E ratio. Popularized by Professor Robert Shiller, the P/E ratio measures the price of the stock market relative to the earnings of the companies that make up the stock market. The higher the P/E ratio, the higher the price of the stock market relative to the underlying earnings of the companies that make up the stock market.

So, what does the CAPE ratio say about the U.S. stock market today? Well, it says the market is the second most expensive it’s ever been – with the most expensive time being during the Tech Bubble of 2001-2002.

CAPE or Shiller P/E

U.S. stock valuations are the second most expensive they’ve ever been. When will it matter?

We believe that valuations do matter and they can impact hypothetical expected returns, but the time horizon is longer than people would like. Over short periods of time, valuations are typically not indicative of future returns (nor is past performance indicative of future returns). For equities, the idea that stock returns will be higher when the current P/E is low and lower when the P/E is high, is not linear for return periods less than about 10 years. In other words, for any given 5-year period time, stocks can act both rationally and/or randomly. However, wait long enough, and the valuation connection often emerges.

Investors often don’t want to wait 10 years for capital markets to act rationally, or for valuations to ring true. Returns in the short run often drives investor asset flows.

However, if you study all the ways to try to estimate how markets are going to unravel, valuations seem to be the best that anybody can come up with. In general, if prices are high and earnings are low, it’s probably not an attractive investment. And if the prices are low, and their earnings are high, it’s probably attractive.

Is there a connection between valuations and risk? Can valuations help with risk management?

We believe there is evidence to support the conclusion that there is a connection and that valuations may help with risk management. You’ve got “value” investors who look beyond market volatility and jump in when prices are low. They might think, “This is too good of a bargain to turn down.” Then, there are many investors who tend to buy stocks that are higher in price—and not wait for it to “go on sale.” However, valuations tend to depict a long-term picture for asset prices, which may help with risk management, expected returns, and building a long-term asset allocation.

What about bonds?

It’s not just large cap U.S. stock that are near record valuations, bond yields are near all-time lows.  Bond yields are a direct reflection of the return that investors can expect, as the yield is the return component of a bond.  Thus, when bond yields are low, investors return will be low.

U.S. 10 Year Treasury Yields

If stock prices are high and most bond yields are low, does that imply that the 60/40 portfolio is doomed?

While the historic return of the 60/40 portfolio since 1926 achieved a return of 9.1% a year[1], we believe expected returns will likely be significantly lower due to high stock valuations and low bond yields. Not “doomed” but low.

The problem is that a lot of people haven’t reset their expectations. It feels like many people are a little lulled into believing that the markets, both bonds and stocks, go up every single year.

So, what can investors do?

While we wish we could look at a stock market backwards and say, “Oh wow, let’s buy here at this low and sell at this peak”, unfortunately, as investors, we must go forward – not backwards. Now more than ever, we believe it’s important for investors to:

• Diversify – Simply owning a portfolio that is a naïve combination of U.S. stock and bonds might not be enough diversification for the future.
• Choose a proactive, risk-managed investment approach – Historically, both stock and bond markets experience more volatility following periods of high valuations, so we encourage investors to choose an asset management firm with a proactive, risk-managed investment approach.
• Consider actively-managed mutual funds – ETFs and Index based mutual funds often represent full exposure to market movements, while actively managed mutual funds are able to adjust as well as to seek to manage risk.
• Think about a tax-managed approach for taxable accounts – If expected returns are low, the impact of taxes can be a more significant portion of the return. A tax-managed investment approach may help investors keep more of their returns.