As stock market valuations sit near all-time highs you may be wondering what this means for the future of your portfolio. The only rival of fundamental stock ratios to our current time is the glorious Tech Bubble itself. Famous and well back-tested measures such as the CAPE ratio and our own Market Risk Index can help provide insight as to what future stock market returns might look like for domestic equities.
What is the CAPE Ratio?
The current CAPE ratio, developed by famed economist Robert J. Shiller, currently sits at a relatively high 30.23. The CAPE ratio takes historical 10-year earnings to provide a smoothed picture of stock market valuations. Historically the ratio norm rests at a moderate 17. However, over the last quarter decade, the normal has been around 23.
Again, the current ratio is at 30.23 with the ratio coming in as high as 34 in 2018. The only former period to eclipse our present situation is the Tech Bubble when the ratio topped out at an astounding 44.
The investment research company, Research Affiliates, takes these ratios into consideration when projecting their capital market returns. Based on their research, and given current valuation levels, the US Large Cap market has an expected 10-year return of 2.7 percent. This doesn’t exactly get anyone excited about the potential growth of domestic stocks. Rob Arnott, the Chairman of Research Affiliates, has commented that valuation levels in Emerging Markets and other international developed counties provide a much more compelling long-term story than the U.S. He discusses in his podcast why he thinks U.S. stocks are still too expensive.
Hedgehog’s Market Risk Index
Looking at our own research and models, we show that we are very much in alignment with Research Affiliates’ outlook. Our Market Risk Index, or MRI, reads 76.6 percent out of a possible 100 percent as of the day this article was written. The MRI is meant to assist investors attempting to gauge the level of overall risk in United States stocks given current economic measurements. The higher the percentage of the index, the greater perceived risk there is in the United States economy. The MRI takes these various economic measurements and assesses how much risk persists in the market relative to all other data points going back to 1948.
A reading of 76.6 percent puts the index in our second lowest grouping in terms of expected future returns. Average 12-month future returns when the index is between 60 and 80 percent have been four percent. However, 76.6 percent lays towards the top of this range meaning an even lower future return is likely. In addition to this the index hit a high of 81.48 percent on September 30th of 2018. Again, signaling poor, if not negative, future market returns over the next year.
What does this mean for your portfolio?
Does this mean you should be out of stocks altogether? That there is a market crash to come? Well, not necessarily.
While the market outlook may seem a bit sour, our Stock Bond Rotation Model (SBRM) still holds max equities at all different risk tolerance levels.
If you plan to select individual stocks as a portion of your portfolio, you need to do your homework. In a market that is priced for perfection, a focus on quality companies with true advantageous value propositions is a must! Make sure you are selecting fundamentally strong companies with solid cash flows and strong fundamental ratios. Emerging Market stocks also contain many areas of value relative to U.S. equities. But beware, a decrease in revenue to corporations, domestic or abroad, may translate to poor EBITDA and poor EPS for firms. Companies falling into this category will surely be treated as the redheaded stepchild by the market. Using strategies found in the CAPE ratio or in our Market Risk Index can help ease your investing process.
If you worry about future market returns and wonder where to put your money, when to buy or when to sell, subscribe to our models. In them, you will find detailed information on how to move your money and when the best time may be. Feel free to contact us with any questions you may have regarding our models.