I’ve written plenty about the markets over the past six months since I started growing the correction beard. But I regularly get questions related to one post or the other that I’ve already answered somewhere else. So I thought I’d try to write a more comprehensive view aggregating much of what I’ve written over that time so it’s all in one place. The underlined words and phrases below link to articles for further reading.
The stock market has done very well over the past six years. In fact, there are only a few other times in history where it’s seen a 200% rise in such short a time. This has led many to believe that investing in the stock market is an easy game when they should really be on guard against just this sort of hubris.
This may be the single greatest mistake investors make – extrapolating recent performance out into the future, especially after the sort of historic run we have seen lately. Momentum can be a powerful force and even an effective trading strategy on its own but in this case long-term investors are likely to be sorely disappointed. Stocks are just as overvalued today as they were in 2000. Why, then, should, investors expect a vastly different result?
You may counter this idea by saying, ‘forecasts like that aren’t usually worth much,’ but, in my humble opinion, everything is a forecast. Buying stocks today is making a forecast that they will generate an adequate return over the coming decade. If that’s what you’re doing, I challenge you to show me why your forecast is more valuable than mine. I’m sincerely curious. And please know that in making this forecast, I’m not trying to scare you. I’m trying to help you.
Like some very smart people I know, you may also try to justify the extreme overvaluation in the stock market right now by pointing to ultra-low interest rates. Rather than justifying high valuations, though, low-interest rates confirm the idea that equity returns will also be ultra-low going forward.
Because stock market valuations have remained so high for so long, it’s very tempting to believe “it’s different this time.” It’s not. The simple reason that valuations have been so high for so long is that over the past 25 years there has been unprecedented demand for equities from the baby boom generation. But this is coming to an end very quickly. Ultimately, this may prove to be one of the worst times in history to own equities.
Just for a minute, look at the markets like Warren Buffett does. 10-year treasury bonds currently offer a better prospective return over the coming decade than equities do (based on the most reliable models), a fairly rare occurrence. In the past, if you just sold stocks and bought bonds during these times you missed most of the major equity bear markets of the past half century (and did especially well last year).
I acknowledge, however, that the trend is still up for the major stock market indexes. So maybe you would prefer to stay involved until the trend changes. That’s absolutely valid so long as you have a plan. As we learned in the late 1990’s, an expensive market can get even more expensive though I believe we are unlikely to see another such blowoff this time around.
Why is that? Because bond market risk appetites have already signaled a shift in investor sentiment that began last summer and stocks are historically very highly correlated. All sorts of demand sources for equities also seem to be drying up. In fact, it looks as if everything but the stock market has already peaked. This is probably why the smart money has begun to worry about the downside.
So I encourage you to have this conversation with your advisor. Take some time to understand the risks in relation to the potential rewards from being involved in equities right now and what that means to you. There’s wisdom in insecurity. And be aware of what this relationship ultimately costs you. In this new era of ultra-low returns it’s more important than ever to avoid the “new wolves of Wall Street.”