The market is overvalued. It’s expensive. Better stop investing in stocks now. These phrases are uttered consistently in financial circles today.
I don’t disagree. With the expensive part at least. The Shiller P/E 10 ratio currently hovers around 28. For those who haven’t been formally introduced to the Shiller P/E 10, let me explain. The ratio is a valuation measure that takes the annual earnings per share of the S&P 500 for the past 10 years and adjusts those earnings based on inflation. The average of the 10 year real earnings is then divided into the current level of the S&P 500 to arrive at the P/E 10 ratio.
The historical mean of the Shiller P/E 10 ratio is 16.7. So at a current level of 28, this suggests the stock market is very expensive. But as an investor, should you care? That depends on two things. Do you have a long-term investing horizon, and do you have a crystal ball? If your answers are yes and no to those questions, then I’d say no, you shouldn’t care.
When Will The Inevitable Occur?
At some point, we will see a market correction. It’s inevitable and has happened as long as there has been a stock market. The question is when will that correction happen? As we know, timing the market is a fools game. There’s no way of reliably predicting when the next market correction will occur.
Let’s turn to baseball for an example. Mike Trout is one of the best hitters in the game. He has a lifetime .306 batting average and hit .315 in 2016. During one particularly rough stretch in 2016, Trout had just 8 hits in 40 at bats. That’s just a .200 average for one of the best hitters on the planet. During a four-game stretch in that period, Trout went just 1 for 14. I guarantee you the announcers proclaimed he was “due” multiple times during that stretch. The law of averages tells us that a hitter this good will eventually bounce back. But when? Five games into the rough stretch, he had just 3 hits in 17 at bats. He was definitely “due” then, but would go on to muster just 5 hits in his next 23 at bats. That’s a little better, but still not very Trout-like.
In the next 14 games, Trout hit better but still didn’t have that major correction we were expecting to see. Then it finally happened. Trout began a nine-game stretch where he hit a sultry .541, with multiple hits in all but one game during that stretch. Those watching Trout play every day last season knew a stretch like this was coming. A great hitter like him doesn’t stay down for long. But could they have guessed when it was going to happen? Nope. Not without a crystal ball.
Are You a Nostradamus?
Now let’s take a look at my first question above. Do you have a long-term investing horizon? If the answer is yes, then don’t waste your time worrying about the right time to get into the market. The right time is NOW so you can let compounding work its magic. “But I’m scared of getting into the market right before the next big correction,” you say. That’s a valid concern. If we had our choice, we would put all our money into stocks when the market is at its low point and pull it out at the high point. But this just isn’t feasible for mere mortals like you and me.
Think back to 2011. The same cries of “the market is overvalued!” were being shouted back then. The Shiller PE Ratio was high back then too, ranging from 20 to 23% during the year. That’s well above the long-term average of 16.7, again suggesting the market was overvalued. Had you listened to the naysayers and pulled your money out in fear, you would have missed out on growing your portfolio by a total of 83% over six years. That’s an average annual return of 11.41%. And stocks were considered “expensive” that entire time.
Investing WithTime On Your Side
Let’s look at some more real world examples from history when stocks were considered overvalued as they are today. The Shiller P/E 10 ratio was at the same level it is today back in 2004. It hovered around this level until the financial crisis reared its ugly head in 2008. Prior to that, it was at this level in 1997 and rode the dot-com boom up to a record 44% before the market came tumbling down in 2000.
Say you had started investing in 1997 when the Shiller P/E 10 ratio was at the level it is today. Assuming you reinvest dividends, your average annual rate of return would be 7.2% from 1997 through 2016. Your portfolio would have doubled nearly twice during this time period. That’s not too shabby for experiencing one of the worst ten-year investing periods in history. I used IndexView developed by Tristan Hume for the charts below. It’s a really cool tool. Check it out!
Recovering from Two Significant Crashes
Let’s say you came of age a bit later and started investing in 2004. Again, the Shiller P/E 10 ratio was at the same level that it is today. In this 13 year period, while weathering the worst recession since the Great Depression, you would have had an annual rate of return of 7.15% through the end of 2016. Not bad at all for starting when stocks were considered very expensive.
Weathering the Storm of the Great Recession
Now we’ll say your timing is incredibly terrible. You started investing in 1929, just before the greatest stock market crash in modern history. The Shiller P/E 10 ratio was again around 28% in the months leading up to the crash. If we look at just the 17 year period from 1929 to 1945, the average annual return of the S&P after reinvesting dividends was 2.5%. So during one of the most trying times in history which saw the Great Depression followed by the most devastating world war in history, your investment portfolio still would have increased by 50% over 17 years.
If you were a diligent investor and stayed true to your plan over 30 years through 1958, your portfolio would see average annual returns of 7.77% and would double more than three times. By the way, this is considered the worst period in recent investing history. And you still bagged nearly 8% annually. If you stuck it out for 40 years until 1968, your portfolio grows by 8.71% annually and doubles nearly five times. So despite picking the worst possible time to start investing, because time was on your side, you still received a respectable return.
Recovering After the Darkest Days
Don’t Fear The Unknown
The purpose of these examples is to highlight that as long as you have a long enough time horizon to invest, you’ll end up just fine even if your timing is terrible. Time in the market beats timing the market due to the miracles of compound interest.
For me, I’m not worried about the current valuation of the market. The very designers of the P/E 10 ratio have gone on record as saying it’s not designed to predict short-term returns. We’ve seen points in history where the market has been overvalued, only to continue to go up for several more years. At other times in history, we’ve seen an immediate correction that brings stocks back down. There’s just no way to predict it.
That’s not to say that I think the stock market will continue to go up for years on end. But just as baseball pundits didn’t know when Mike Trout would break out of his slump last year, we don’t know when the market correction will happen. Therefore, I’m sticking with my plan to continue to invest in stocks on a regular basis. I’ll continue to reap the gains of the stock market for as long as they last. And when that downturn comes, I’ll pick up plenty of shares on sale.
Readers, how do you currently view the stock market? Are you scared off by the current high valuations, or are you continuing to ride the wave?