What I'm writing about today is one of the most pressing dilemmas facing investors right now: "Where do I invest my money when everything looks expensive?"
My friend Alfonso Peccatiello summed it up well recently in this meme:
Whether you look at stocks, bonds, property – or limited edition sneakers! – any asset class you might want to invest in today looks expensive.
The Stock Market
Let's begin by looking at the stock market.
If we study the US market through the lens of the so-called "Warren Buffet Indicator”, the valuation of stocks is at a record high.
The stock market capitalization to GDP ratio is significantly higher than it's ever been. Today it’s eclipsing the levels seen in both 2000 during the tech boom, and in 2007 just prior to the global financial crisis.
Another popular long-term measure of stock market valuation is the cyclically adjusted PE ratio – or Shiller PE. This valuation metric compares stock prices with the average of the past 10 years of earnings.
The Shiller PE is currently 39.65, which is higher than at any other time in history, except the peak of the tech boom in 2000.
This is potentially important information because the Shiller PE has been a remarkably accurate at predictor long-term future stock market returns.
If you invest money in stocks when stocks are very expensive, your returns will be lower than if you invest at a time when stocks are cheap. Your starting point in the investment game matters.
CAPE predicted 10y returns verses actual returns during 1995-2020 showed an r-squared of 0.9 and a standard deviation of 1.37%.
In other words, CAPE explained 90% of future stock returns, and 67% of the time, future returns were within 1.37% of the predicted return.
The current Shiller PE level of 40.15 implies average annual returns for the S&P 500 of -0.7% per year for the next 10 years.
Now let's look at bonds
The role of bonds in an investment portfolio has traditionally been to:
– provide a source of regular and reliable income;
– preserve capital; and
-to hedge against a slowdown in economic activity – which is usually bad for stock prices but good for bond prices.
US 10-year Treasury bonds currently yield approximately 1.5%. A miserly income stream, I'm sure you'll agree.
But it only gets worse when you consider that the US inflation rate is currently running at 6.8%.
The REAL bond yield – which is the bond yield minus inflation – is the most negative on record.
This means that bonds, too, are very expensive. And when bonds are really expensive, they do not pay much income (hence the negative real yield). Their ability to protect your capital is also compromised by their high valuation, because over-valued assets can become fairly (or under) valued.
Finally, let's take a quick look at residential property.
Much ink has been spilled on the housing affordability crises that are prevalent in many housing markets across the world.
We have seen an acceleration not just in house prices, but also in house prices relative to incomes. This is of course what really impacts affordability. This surge in house prices relative to incomes has been facilitated by low interest rates and skyrocketing household debt levels.
The net result? Millennials have been completely priced out of the property market in many countries globally.
It’s important to understand that none of what I've discussed in this blog means stocks, bonds and housing can't become even more expensive in the short to medium term.
Valuation is not a good timing tool…but it can be an excellent predictor of future returns over the long term. And current valuations are not attractive (refer Shiller PE above).
If you're uncomfortable buying or owning investment assets that are looking really expensive by historical measures, what should you do?
Change your mindset
At this point in the cycle, I strongly encourage you to change your mindset. Change your approach to how to take on and manage risk.
Change your mindset from one of:
"I'm going to own a portfolio of risky assets through thick and thin and hopefully, fingers-crossed, I'll come out of it ok in the end if everything keeps going up over the very long term."
And adopt a mindset of:
"I'm going learn how to make money in both rising AND falling markets. I'm also going to learn how to identify high probability moments in time to expose my investment capital to risk, rather than have it exposed to risk all of the time in an expensive market"
Identifying these high "probability moments in time" is not only possible, it's quite simple when you know how.
Wall Street wants you to believe it's impossible, because they want to charge you a heap of fees for managing your portfolio. They've got no interest in you empowering yourself to manage your own money.
But if learning how to identify these high probability moments in time interests you, that's where my online education company Tao Of Trading can help.
We offer world-leading education programs that will guide you through the process of identifying high probability moments in time to buy or sell, while managing your risk like a professional.
Our methods are renowned for being simple, intuitive, highly visual and of course very effective.