US stocks continue to bob along at their third most expensive level since 1871. Each time the market has matched or exceeded current valuation multiples it was followed by a crash of between 40% and 80% over a few years. It’s clearly inadvisable to buy today. But a reader who’s been building a position at lower levels over many years asks whether he should sell.
For my most recent analysis of how expensive US stocks are, in case you missed it, take a look at these two articles from earlier in the month:
These articles prompted a reader called George to write to me. (Any time you have comments or questions please send them to firstname.lastname@example.org)
George’s email covers a lot of ground which I’ll attempt to answer. So without further ado, take it away George…
Interesting articles about the US stock market being too expensive. That may be true for short term, but I’ve always looked at the US market as well as the international market as a long term investment.
If you say to stay out of the US market, then does that also mean you should sell all of your equity positions? That would be a form of market timing and I believe market timing is doomed to fail.
I stay invested in the market because even if the market drops 40% I really don’t care because I’m in for the long haul. Since I dollar cost average every month, I will be buying more shares went the market drops. To me a loss in the market is only when you sell!
I’ve seen this play out before back in 2000 and 2008, and I don’t panic and sell. I’ve seen my friends and old co-workers sell at the bottom and buy at the top. Some sold at the bottom in 2008, 2009 and they are still waiting seven years later when to get back in the market. They’ve missed the ride of the wave up in the market rally. Not to mention all the income gains, dividends, and compound interest.
By the way I’m a big believer in index funds. Also I use asset allocation, diversification, and re-balance. Sounds boring because it is.
There’s a lot in there to unpack, but I’ll do my best to give brief thoughts on each. Investing for the long term…market timing…dollar cost averaging…realised versus unrealised profits and losses…keeping emotions in check…index funds…asset allocation and rebalancing…diversification…
But first let’s deal with that “boring” issue. It’s certainly true that few people study finance and investment as a hobby. Most prefer something like fishing or fast cars.
Professionals get into finance to make money. They do that by separating you from yours…with fees, trading spreads and brokerage commissions. Only by getting on top of how it all works do you stand a chance of coming out alive. It may seem boring, but it’s also essential if you don’t want to lose most of the value of your money over time.
Anyone with savings, a pension fund, or other investments – or simply the intention of building them in future – needs a reasonable understanding of what’s going on. Otherwise they will lose what they already have, let alone build on it. OfWealth aims to help.
Even the apparently “low risk” option of sitting on cash savings will kill your money in the long run, as inflation and taxes eat into the value of the money. Anyone can do much better than that, with a modest application of time.
Let’s get back to the issues in George’s message. Firstly I congratulate him on his long term and calm approach. Keeping your emotions in check is essential. For more see: Learn to control your inner monkey.
Patience is key if you want to be a successful private investor. Investing a large part of your portfolio in stocks is also hugely important, if done in the right way. Stocks are one of the best places to make money over the long run, vastly outperforming cash and bonds. For more see: Successful investors need these two things.
That brings us on to the question of asset allocation. All investing starts with working out what assets to buy and own. There’s a lot to choose from, as our Wealth Tree infographic shows (see here, scroll down and click on the image).
However much you like the look of one thing it’s essential to stay diversified at all times. That way you may get something wrong but you’ll avoid a wipe out.
Right now I recommend that your financial investments should be spread across stocks, gold and cash. “Cash” means mainly bank deposits and cash equivalents like US treasury bills (very short term government bonds).
Most people also include an allocation to bonds. But since we’re in a 500 year bond bubble – with yields at record lows, or even in negative territory – I don’t think bonds are worth owning (for more see here and here). The tiny returns on offer aren’t worth the substantial risks. One day inflation and/or yields will start to rise and bond investors will get taken to the cleaners.
Stocks can be broken out further. George likes index funds, such as those that track the S&P 500 index of large US company stocks. Buying a broad index gives instant diversification across a wide range of companies. Some good, some bad, some cheap, some expensive. Overall you’ll usually do pretty well with index funds, in the very long run at least.
Searching for better opportunities abroad is even more important when your home market is expensive, as the US is now.
But there’s room for more than just a home country index fund. The world is a big place, and so are its stock markets. Bargains can be found throughout the world, such as that offered by Russian stocks these days (see here). Searching for better opportunities abroad is even more important when your home market is expensive, as the US is now. You can also invest in individual company stocks when the prices are attractive, especially if they are big, safe companies.
Most asset allocation strategies set percentage allocations for different investments. So you might have, say, 50% in US stocks, 20% in emerging market stocks, 10% in gold and 20% in cash (not a recommendation, just an illustration). You expect all to go up over time, except the cash, but not necessarily every year or in a smooth way. The cash is there to sweep up bargains after the next crash. Think of it as “ammo”.
Once a year you check the weightings, and sell a bit of whatever has become overweight to bring it back into line. Then the cash proceeds are used to buy more of whatever is underweight.
Repeated over many years this kind of approach has been shown to give excellent results. You’re constantly selling stuff that has become more expensive and buying stuff that has become cheaper. But all of it goes up in the long run – at least if you’ve chosen the right asset classes in the first place.
Now let’s get to the real crux of George’s message. If you’ve already got a lot of US stocks, should you sell them?
George uses “dollar cost averaging”, and has presumably been at it for a long time. If you haven’t heard of it this is the process of buying more stocks each month, using money from your salary or other income.
You don’t worry about the price. You just buy automatically, adding to your overall investments each time. Depending on the market, sometimes you pay too much, sometimes you get a fair price, and sometimes you get a great deal.
Over time it averages out and you get an average market return. You’re not trying to beat the market, but just to match it. Although, if you’re doing asset allocation and annual rebalancing as well, you should improve the overall result. Even if you’re not, getting an average stock market return over your entire multi-decade investment span will typically put you head and shoulders above returns from bonds and cash.
If you’d been doing this with US stocks for 10 or more years then you can relax. The average purchase prices will have been well below the current level. You’ll make solid profits on old investments bought at lower levels, even if the market falls. And if prices fall you’ll get to buy more at lower levels. When they recover again you’ll make up for the losses from buying at or near the top. Dividend income is also reinvested, so you get the maximum power of compounding (profits from your reinvested cash profits).
Selling lower than you bought makes a realised loss, as opposed to just an unrealised price fall. If you realise a loss and quit the market then you’ll miss the bounce that will eventually follow.
The crucial thing is not to panic if there’s a crash. Not to sell at the bottom, or to stop buying at that point. Selling lower than you bought makes a realised loss, as opposed to just an unrealised price fall. If you realise a loss and quit the market then you’ll miss the bounce that will eventually follow.
However, with the US stock market at such a high level now, the dollar cost averager should consider stopping new purchases, or investing the funds in more favourably priced markets. The same goes for those that find they are heavily overweight the US stock market after a seven year bull run. They should reduce the position and find better opportunities.
Market timing is a tricky business because what drives prices in the short term isn’t just fundamentals, but also things like trader sentiment and government interference. However, you can get a pretty good idea of whether what you own, or what you usually buy, is selling for a reasonable price. That, in turn, will give you a pretty good idea of the outcome you’ll have over the long term.
We can’t know what the immediate future will bring, which is why I recommend you focus on what you can know today, such as general valuation levels. For more see: Why great companies can have bad stocks.
Whatever your view of the US economy, or the prospects for future US corporate profits, US stocks are expensive. Starting from this level makes them highly unlikely to be rewarding investments in future. Invest accordingly.
Stay tuned OfWealthers,