Today there are many signs that we are in an investment “bubble.” Michael Finke, Professor of Wealth Management at The American College of Financial Services defines a bubble this way: “A bubble occurs when the price of an asset inflates well beyond its fundamental value.” He goes on to say, “Bubbles often form when the imaginations of investors (speculators?) are inflamed by unrealistic expectations, sharp price increases, and fear of missing out.”
These descriptions could well apply to everything from Tesla stock to Bitcoin to Gamestop stock to single family homes.
The Shiller Price to Earnings ((PE)- Price of stocks compared to their actual earnings) chart above is just one of many measures showing the overall stock market to be extremely expensive. It has only been more expensive just once before – in 2000 right before stocks dropped between 50% – 70%. In the past when stock prices have been at this level, they have averaged just .5% return per year over the next 10 years.
While we do not know what the market will do in the future, history suggests that after booming markets like we have just experienced it is common to have a lengthy period of falling or flat prices.
Here are a few examples:
Taking these charts together we can see that the market has been negative or flat for long periods of time after significant market run ups. In fact, the market has been flat or negative for about 53 out of the last 92 years. This is important to remember after the nearly uninterrupted rise of the last 13 years.
Given the likelihood of a sideways market, how should we invest? Here are some of the key strategies:
- Active Value investing – Avoid overpriced stocks that could drop substantially when the market changes and buy stocks that are selling at a discount to their actual value. When your stocks get overvalued sell and look for undervalued ones. If there is nothing available hold onto extra cash until you find something suitable. Journey Tree seeks to use mutual funds that emphasize this and other risk management techniques.
- Increase the margin of safety – A margin of safety allows you to avoid major losses should specific investments or the market overall decline significantly. By avoiding overpriced stocks, and buying stocks at a discount, we can increase the margin of safety. Having extra cash we create a buffer to help protect your portfolio.
- Value cash – Not only does cash hold its value when markets decline but it also provides funds to buy stocks and other investments that have dropped to a price that makes them attractive long-term investments. While it is true that, currently, cash provides no return given historically low interest rates, it does not lose value as many other investments are likely to do in a bear market. Short-term bond funds can also be used in lieu of cash to some extent to generate some income while having minimal downside risk.
- Invest globally – Each geographic region has a different risk/return profile. The U.S. is one of the more expensive markets in the world but there are other countries that may offer better opportunities. For instance, European stocks are still below the peak they reached in 2007 and some Asian stocks offer better value and growth prospects. Diversifying across the globe makes a lot of sense, especially with U.S. stocks becoming a smaller percentage of global stocks.
- Use Alternative Investments – While many stocks are overvalued and many bonds pay little income, there are other non-stock/non-bond investments that can potentially provide a relatively consistent source of return despite stock and bond market volatility. Floating Rate funds, Market Neutral funds, and Merger Arbitrage funds are some examples of investments that perform largely independent of the stock and bond markets.
- Focus on income – Portfolios geared toward producing income from interest and stock dividends usually hold up better in rocky markets. This type of income can provide a significant portion of the return you need while reducing the fluctuation in the value of your account.
Contrary to recent experience, as the charts above make clear, markets do not always go up. It is important to be adequately prepared for what the future is likely to bring.