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Investing when the market is expensive

Posted By The Investor On In Investing,Commentary | 15 Comments

The US stock market is expensive by historical standards. Given that it now comprises almost three-quarters of some global index trackers [1], by association those funds look pricey too.

For instance, here’s the geographic exposure of the iShares Core MSCI World global tracker fund (ticker: SWDA):

[2]

Source: iShares [3]

Some readers expressed scepticism when I began pointing out the US was about two-thirds of global markets a year or two back. Now its plus-plus-sized status is indisputable.

I wonder if screenshotting that factsheet above for evidence will seem like some kind of symbol of the excess in years to come?

“People used to just accept it as normal that the US market should be more than 70% of global trackers,” they may say in 2035. “Doofuses!”

But no, people are not complacent. Almost everyone who pays attention to what’s in their portfolio – investors who’d call themselves investors – knows the score. And it often worries them.

A reader emailed me this week:

There’s been a big uptick recently in warnings about stock markets being in bubble territory – not just from pundits, but from the likes of the Bank of England, the IMF and Jamie Dimon.

So how should a basically passive investor – who nonetheless does think bubbles can happen and that we have an AI bubble now – behave in such circumstances?

Personally, if I owned the global stock market – with around 70% in US equities, heavily weighted towards tech stocks – I’d be feeling really jittery. I’ve already skewed my equity holdings somewhat away from US equities.

People are making the obvious comparison with the dotcom boom, which was succeeded by a decade of sluggish returns in US stocks. But not many people – including, I expect, not many of your readers – were heavily invested at the time.

Obviously Monevator doesn’t provide advice, but I expect it can provide some helpful ways to think about this!

I’ve had a dozen emails or comments like this in the past month. Often they’ll add they know Monevator doesn’t write about such matters – market timing, boo hiss – but could we make an exception?

This is puzzling to me because we do write about such stuff. Quite often!

Indeed I sometimes fret that we write about it too much, and so potentially put would-be passive investors on a path to meme stock [4] punting.

Today then I’ll answer our (splendid) reader’s question by pointing you towards a few of those answers we’ve given earlier.

Firstly, what exactly are we worried about?

Discussion about frothy market levels may conflate at least four things:

I’m not being pedantic. These statements imply different things. Taking action with a passive portfolio on account of any of them will probably do more harm than good for most people, most of the time – that’s what the data [6] says anyway – so you should know what is bothering you before you try to fix it.

For instance, a market may appear expensive on the basis of P/E multiples. But if we’ve been in a recession that’s ending and earnings are set to bounce back, a high P/E [7] will rapidly come down.

Or: markets can go up very quickly and keep going up for many years more. They can rise especially fast out of bear markets – when, ironically, investors may be too shellshocked to trust those gains.

Also a stock market isn’t expensive just because it is ‘high’. During a 40-year investing career you’d hope to see the major indices hit many all-time highs.

The S&P 500 index was well under 1,000 in the mid-1990s. Now it’s pushing 7,000:

[8]

Source: Yahoo [9]

The S&P has returned more than 800% over the past three decades, and that’s before dividends. Selling just because it’s ‘up a lot’ is silly.

And yet many investors – even old-timers – seem to see equity markets as like sine waves, to be surfed on the ascent and pulled out of before they tumble.

Yes, day-to-day – even year-to-year – stock markets can be as choppy as any semi-rideable British seaside wave.

But long-term investing in shares is much more like mountain climbing than surfing.

The US market is expensive

Arguably the most credible guide [10] to a market being genuinely expensive in light of all this is the CAPE aka Shiller aka P/E ratio. All names for basically the same thing – a metric that reflects the price you’re paying for company earnings averaged over a longer time period.

Such a ratio aims to smooth out the peaks and troughs of economic cycles and market tumult, and so to give a better long-term reckoning.

However in a very venerable CAPE ratio [11] explainer for Monevator I wrote:

…cyclically-adjusted PEs may be a useful tool, but I don’t think they’re the silver bullet they’re sometimes touted as.

Read that post to learn more about cyclically-adjusted P/E ratios. Then push on for more thoughts about how much to really care about what they are saying.

So what is the ratio suggesting now?

Going by the Shiller-flavoured PE ratio, yes the US market looks very expensive:

[12]

Source: Multpl [13]

The last time we approached these levels was on the eve of the Dotcom crash. Even our youngest readers will have heard about what happened then [14]. If you’re ever going to judge it be squeaky-bum time on the basis of P/E ratios then now is the time, at least when it comes to US stocks.

Last week I included a similar graph in my Moguls post [15]. The ratio was below 40 then, so we’ve already pushed above it.

It’s not inconceivable the ratio could moderate without a bust. Perhaps advances in AI really will unlock huge productivity gains and boost earnings beyond all imagining. Maybe it could even do that, somehow, without simultaneously capsizing the rest of the economy and its incumbents.

Either way, the justification for using long-term cyclically-adjusted valuation multiples is we’ve heard this sort of story many times before – railroads, mainframes, biotech, Internet stocks – and it tends to end the same way. Excess followed by retrenchment. The results are in that graph.

People thought it was different those previous times, too. And it generally was in some ways, as far as society is concerned.

But for stock market investors it mostly wasn’t.

Can market levels or valuation help with market timing?

Again yes and no. But mostly no.

While confident-sounding pundits and bloggers are forever mining and showing off new indicators, the consensus of the academic research is that even the cyclically-adjusted ratio is a lousy timing tool.

Nobel Prize-winning Professor Robert Shiller – who gave his name to one flavour of such ratios – has said much the same thing [16] in the past.

Also, you’ll notice I said ‘academic research’. Finding cute ratios or indicators in a dataset and ruthlessly applying them in a model is one thing. Actually implementing this stuff in real and crazy life – when markets are ripping or swan-diving – is another.

Perhaps that’s a good thing.

This is survivorship bias and anecdote speaking of course, but I’d bet more money has been lost this century by people too scared of investing in appropriate size after the Dotcom bust and the Financial Crisis than by those who took a pounding and supposedly sold at the bottom of a bear [17], never to return.

Still, a high cyclically-adjusted P/E ratio has ultimately been shown to be the best of a bad bunch of potential indicators when it comes to estimating future returns.

Again that ‘best’ is doing the heavy lifting. A Vanguard study [18] found the ratio had historically explained about 40% of future returns. Better than the alternatives, but that still left 60% of returns to account for.

You Shilly boy

Want more evidence? The article I linked to above where Shiller warned that his ten-year cyclically-adjusted ratio wasn’t a timing tool hails from 2014.

In that same piece Shiller nevertheless opined that when it came to US stocks, “It looks like a peak”.

The US is up about four-fold since then. I imagine he’s glad he hedged his bets.

This market timing stuff isn’t easy. It’s either hard or not possible.

Certainly it only looks easy in hindsight. But people predict crashes literally all the time, so someone will sometimes be proved right, even by chance, and they will later dine out on it. So it goes.

Incidentally if you’re thinking “it is easy if you study Fibonnacci levels or Kondratiev waves” – in other words technical analysis [19] – then (a) I’m skeptical and (b) this isn’t the article for you and (c) I still reckon if it ever works then that it’s only obvious in hindsight [20]. With knobs on [21]!

Market timing for passive investors

Many readers assume Monevator is against all forms of market-timing, second-guessing, or risk management through portfolio reshuffling.

However that puts our position far too dogmatically.

For a start I’m in the mix. I’m an active investor [22] and I’m all too happy chopping and changing around.

The key for me – and a suggestion I’d make to other active investors – is to at least try to understand the risks and downsides of carrying on this way though. Think performance chasing, loss aversion, excessive costs, FOMO, over-confidence, and a gamut of other behavioural and mathematical reasons why churning your portfolio willy-nilly is probably not the route to riches. Know the rules before you break them.

So much for active investors. But Monevator suggests passive investing [23] in index funds is the best approach for most readers. So that’s the real question. Not how well I’m taming my overactive chimp brain from one day to the next.

Fair… but my passively-minded co-blogger The Accumulator is also quite pragmatic about such matters.

Passive up to a point

For example, TA has tweaked our Slow & Steady Passive Portfolio [24] several times. And he’s not shown himself to be averse to trying to swerve from egregiously expensive markets, either. Think of his classic post [25] in 2016 warning of the risks baked into index-linked gilts.

However taking action should never be the default for passive investors. Quite the opposite: don’t just do something – stand there!

As TA writes:

…how do you tell when the moment has come for legit evasive manoeuvres – as opposed to the standard knee-jerk fiddling that just amounts to ill-advised market timing?  

I think the trigger for positive action is when we’re approaching a market extreme. 

The mental image that illustrates such a moment for me is the Death Star moving into firing position against the Rebels in Star Wars.

The battle station slowly rounds the intervening gas giant that stands between the good guys and planet-killing laser death…

You don’t get that kind of imagery in corporate emails from your broker, eh?

Read on for more (alleged) heresy for passive investors:

Is now a good time to invest?

For slam dunk proof that Monevator does discuss these issues, my co-blogger talked about market timing only two months ago.

The Accumulator wrote:

It’s because equities have proven resilient over time that long-term investors stay in the market, regardless of short-term wobbles.

Trying to predict the perfect entry point often means missing out on growth because there is never a ‘safe’ time to invest.

I’d add that you should always think about your time horizon when making decisions. We can’t predict the future, but the balance of probabilities [27] over different time frames means the answer to whether you can reasonably be fully exposed to US equities today is different if you’re 30 compared to if you’re 60.

Some things to do if you’re worried

Over the past decade or so, a lot of the returns from equities – and nearly all the (apparent) froth – is down to technology stocks. At least with respect to companies big enough to move the index dial.

And because the technology sector is to the US stock market what the original Star Wars trilogy is to the nine episode Star Wars canon – that is, only a third of the total but delivering most of the gains – the US markets have been the ones most affected by the long boom in tech.

Oh, and there may be an AI bubble in progress. Or an AI revolution. Pick a side!

At least this focus on US tech affords us an easy way to reduce exposure to what seems to be an expensive stock market: we can dial down tech and/or US stocks.

I wrote [29] about this for Monevator members:

We saw how US equities dominate global index funds and how a handful of giant tech/growth companies in turn comprise a large chunk of the US market.

One counter then would be to hold a wider spread of US companies.

You could track an equally-weighted index, for instance, instead of a market cap-weighted one. You could reduce your exposure to larger US growth stocks and add small or mid cap US shares or US value stocks.

There are countless options. 

The snag? Only that I wrote that in March 2024. Since then the S&P 500 is up another 30% or so.

I have my defences. My members’ post is several thousand words long, for one thing. It belabours the uncertainty, and it explicitly says staying invested and letting the market decide is a perfectly rational plan for passive investors. I also even note that doubling down on tech and trying to maximise exposure to the rally (/bubble) could be a justifiable thing for active investors to do, too.

Also my article never said ‘get out of stocks’. On the contrary it said:

…whatever you do don’t sell all your equities!

Baby steps is the way forward. It’s one thing to modestly tilt away from what may be an extreme in a particular market. It’s another to start making all-in and all-out bets.

In my piece I made a case for more diversification into global stocks – which since March 2024 have done fine, and even better than fine in pound terms – and for shifting to track equal-weighted or value-tilted US indices, to reduce your giant tech exposure.

In doing so investors who underweighted US stocks in early 2024 could still be sitting pretty today is my point – even as US tech has continued its Icarus ascent. So I’ve no regrets.

Besides, when people fret about the US markets diving, I don’t think they’re concerned with maximising short-term gains. They are fretful about a Dotcom-style wipeout of their portfolio.

That’s certainly my perspective, and I’ve been underweight US stocks for at least 18 months now.

Other than equities

The other thing I reminded readers in my 2024 article is that equities – be they US or otherwise – are not the only fruit:

Why not simply reduce your overall equity risk? You curb how badly a US market correction would hit your wealth, without trying to pick favourites among the different regions.

The standard way to alter risk levels with a passive portfolio is just to reduce your equity allocation and increase your bond allocation. (Bonds that are finally set to deliver reasonable returns again, after their big price reset.)

If you were invested 80% in equities and 20% bonds – an 80/20 split – then you could shift to a 60/40 split, for example.

Again, endless permutations.

Now it’s true government bonds haven’t seen much of a recovery from the post-2022 wreckage. But as we’ve explained before [30], that smash-up left them in a far stronger starting place to deliver decent returns [31] in future. Expected returns are very positive, compared to negative in the years running up to 2022.

Meanwhile corporate and high-yield bonds have been going great guns, thanks to low defaults and relatively high income payouts.

Such bonds would be hot potatoes to hold in a recession, true. But they’d probably do okay in a stock market correction driven by a hype-cycle bursting. Particularly if the US cut rates to help steady the ship.

Needless to say gold has been an excellent diversifier of late. How much farther its stupendous rally can run is well above my pay grade – and outside the scope of this article!

Bubble bath

Ironically, one reason not to panic over whether we’re in a stock market bubble is the way that nearly everyone seems to believe we are.

You can barely turn on Bloomberg or CNBC, read an investing newsletter, or talk to a fellow private investor online or off without hearing that we’re in a crazy AI bubble that the unwashed masses cannot see for what it is.

Here’s what Google Trends has to say about the popularity of the search term ‘stock market bubble’:

[33]

Source: Google [34]

When the masses all think that we’re in a bubble, then it’s definitionally difficult to believe that we are.

Time will tell. Personally I think stuff looks peaky, and I’ve said so today and elsewhere. But I’m still 75% ‘risk-on’ in my portfolio currently. Just not too much US market risk – not 50%, let alone 70%-plus.

I’m even still exposed to tech stocks. Mostly through my own stock-picking though. And I’m very (very) underweight the Magnificent Seven. But I’m sure I’ll take a tumble anyway if the US market falls.

It usually pays to be humble as an investor. Lifelong passive investors who believe they can spot a bubble better than the market might want to ponder that. (Active investors should think about it every day!)

Meanwhile my co-blogger will wade further into these waters with his next Mavens member post, which is due on Tuesday.

Sign-up [35] to get it!

Some other relevant reads from our archives: