Stock prices are high by almost any measure. Learn how to protect your investments with what to buy now.
There’s no stopping the stock market. The Dow Jones went on a 12-day streak in February, booming past 20,000 and matching the longest streak in history.
Even at record highs, investment commentary has changed recently. Pundits are no longer calling stock prices too high but have given up and are buying into the craze for more market gains.
Is that a sign you should get out of the stock market? Are stock prices really too high and what is there left to invest in?
Let’s look at stock prices and where they could go before getting to some of the best investments for when stocks are high.
Are Stock Prices High?
I’ve seen a lot of articles lately arguing that the stock market isn’t so expensive. The idea is that new economic growth and low interest rates are on the way and that will support high stock prices.
The problem with this reasoning is that it depends on the future to play out perfectly. The same kind of thinking is used to justify ridiculous stock prices towards the end of every bull market.
In 1999, the internet was supposed to continue to make for huge productivity gains and globalization would mean a surging economy. In 2007, it was that rising real estate prices in the U.S. and fast economic growth in China would continue to provide lots of money for investment that would send prices higher.
The truth is that the future rarely works out as perfectly as investors think. You can’t base your investment strategy on what might be.
The price-earnings multiple isn’t perfect as a measure of how expensive the market is but it’s a simple measure everyone can follow and one of the few with data going back a century. Looking at other measures like the dividend discount model or adding a risk premium on bond rates gives basically the same outcome so we’ll use the P/E measure.
The Shiller cyclically-adjusted P/E (CAPE) ratio goes a step further from just dividing the price of the S&P 500 by earnings of companies in the index. The measure adjusts earnings over a long-term period to account for the business cycle and inflation.
The chart shows the CAPE ratio for the S&P 500 back to 1950.
Some investors have argued that the market P/E ratio has been higher over the last 20 years because of lower interest rates. That’s why I used the data only back to 1950 rather than back to 1929 which is more common.
The average price-earnings ratio for stocks over the period is 19.1 times with the current market multiple at almost 30-times earnings.
Even if you think the long-term fair value of the stock market is around 20-times earnings, it’s hard to argue that this stock market isn’t expensive.
Why are Stocks so Expensive?
Based on that long-term average P/E measure, investors are paying about 50% more for stocks.
The recent chorus of optimism for stocks has everything to do with the new administration in Washington. Growth of the Chinese economy is still slowing, Europe has yet to really rebound from the Great Recession and emerging economies are struggling with lower commodity prices.
But everything looks rosy in the United States.
The new administration and Republicans in Congress have promised to lower tax rates, withdraw regulation and generally boost economic growth.
That’s all great and could lead to higher stock prices but it’s still relying on the future to justify expensive stock values now. Investors are paying more for stocks because future growth will make those prices reasonable…but there’s a huge problem with this reasoning.
In a couple of years, after we’ve presumably gotten this economic growth and higher earnings, investors will need to be just as optimistic about the next few years for stock prices to continue going up.
Look at it this way. An investor is paying $150 right now for the stock market that is fairly valued at $100 (it’s that 50% premium) but says economic growth over the next few years will make $150 the new fair value.
If we get that perfect scenario of economic growth, stocks may reach a fair value of $150 over the next couple of years but the market has to see even more economic growth ahead for stock prices to go up. The investor doesn’t want that $150 stock to stay at that price, they want it to go higher.
Paying a fair value on future growth means the investor is always counting on the economic outlook to continue higher…but it just doesn’t work that way. When investors see the next recession coming, stock prices crumble.
Can the Stock Market Go Higher?
This graphic of bull and bear markets from First Trust Advisors is slightly off from mine and other calculations for the average bull markets but is a good visual for where we are right now. The original graphic only went through 2015 so I updated the numbers on the current market through March 2017.
The most obvious and important thing you can get from the chart is that the market always goes up and down. Investors love to believe that the good times will last forever but they never do.
Comparing the current stock market with past increases here or with the P/E chart above shows that the market can keep going higher. Investors love to chase stocks to the peak and that means more money coming into the market to push prices higher.
But comparing the current stock market with past bull markets this way is misleading because of the huge difference in economic growth in the different periods.
The U.S. economy has grown just 2.1% a year since 2009, way under the 2.9% average annual growth seen in the previous cycle and almost half the 3.8% growth of the 1990s.
Inflation is also another factor making the older stock market surges looking higher than actuality. Inflation over the last six years has been just 1.7% annually, again under the average 3% inflation rate of the previous two market runs.
You wouldn’t expect the stock market to surge as high in a period of low economic growth and low inflation compared to previous bull markets. Comparing the 341% gain in the S&P500 since March 2009 with previous bull markets and saying there’s still room to run just doesn’t make sense.
The fact that this stock market has surged despite low economic growth and inflation may mean that stock prices are even more expensive than most investors think.
But bull markets don’t die of old age and there are reasons stocks could go higher. I detailed five reasons why stocks could crash in 2017 in another post but let’s look on the bright side for a moment.
Borrowing costs are still very low. The Federal Reserve has started raising rates but companies can still borrow easily to buy back stocks. This increases earnings per share because there are less shares by which to divide total earnings. Rate increases by the Fed have been a major turning point for stocks in the past, crushing the stock market in 2000 and 1994.
The unemployment rate is low and claims for unemployment benefits are at multi-decade lows. That’s supporting consumer spending which is 70% of our economy. If the economy keeps growing then investors reason that employment should continue to grow.
The problem here is that employers are already saying it is starting to get harder hiring people. More jobs on faster economic growth will mean more demand for the same number of workers. That’s going to push wages up faster.
Before you think that’s a good thing for the economy and stocks, higher wages means lower corporate profits. Surging wage costs have been another key turning point for the economy in the past, forcing employers to cut staff and leading the country into a recession.
A decrease in the tax rate would mean higher earnings for companies but the effect might not be as much as the market is expecting. The average tax rate paid by Corporate America is already 25% when accounting for deductions. Congress is only proposing lowering the top rate to 20% so the incremental gain isn’t huge.
To get the rate lower, Congress is promising to repeal some deductions like interest deductibility and to use a border tax to offset losses to government revenue. These will all act against any increase in earnings and could leave investors with less than they expected.
Risks of Investing when Stocks are High
Yes, stocks could go higher but how high and for how long?
Investors like to think the good times will last forever but the economy moves in cycles, growth and recession. That’s just how it works. There will be another stock market crash.
Let’s look at an example of what might happen by continuing to invest when stocks are high.
Stocks have lost an average of 42% in the last four stock market crashes. Even if the S&P 500 continues to 2,863 for a 20% gain over the next couple of years, it could still fall to 1,660 in a crash.
That 1,660 is a loss of 30% on where the market is right now!
Everyone likes to think they can ride the market just a little higher, hoping that they’ll be able to get out before the next crash. Investors think there will be signals before a drop in stocks.
How has that thinking worked in the past? Even professional money managers are caught off guard when prices tumble.
Even that hypothetical 30% loss underestimates the real opportunity lost.
If you invest in safer assets now, then let’s say you book an average return of 5% annually for the two years stocks keep going up. It’s going to be painful watching stocks keep rising and missing out on the higher return but with safer assets, you won’t lose your money when the market does fall.
If stocks do crash 40% or more, you’ll have protected yourself. Compared to a stock portfolio that is down 30% over the period, you will be up 57% by switching to safety investments now.
How to Invest When Stocks are Overvalued
Some investors would say don’t worry about high stock prices. If you have decades left before retirement, you’ll likely see the market fall and rise several times. I generally recommend against trying to time the market, jumping in and out of stocks, but there is a strategy you can use to protect your money and still make long-term returns.
A great investment portfolio includes more than just stocks. It’s only by investing in other asset classes like bonds, real estate, startups and peer lending that you’ll be able to meet your investing goals.
If you’re like most investors, you have almost all your money in stocks. Ridiculously high stock prices make now a perfect time to move some of your money into these other assets.
It doesn’t mean you have to sell all your stocks, it may not even mean you have to sell stocks at all. If you invest regularly then you might just put new money to these other assets instead of in stocks.
Sell some of the individual stocks that have skyrocketed and put new money to other assets. You’ll still profit from the upside in the stock market but will start building your protection for when the next market crash comes.
Best Investments Outside of Stocks
There are three investments I’m shifting to as stocks continue to get more expensive. All three of these should continue to offer returns even if stock prices fall and all provide great cash flow.
Real estate investing has long been a favorite of mine. Few assets have created as much family wealth as real estate. Real estate provides monthly cash flow and averages double-digit returns annually.
The problem has always been the huge cost to buy an investment property. You need millions to buy a couple of different property types and in different locations so you aren’t exposed to the risk in any one property. Real estate crowdfunding has helped solve this problem for individual investors, allowing you to buy a portion of many properties for a fraction of the cost.
I use RealtyShares to invest in real estate crowdfunding. It’s one of the larger platforms and offers a good mix of debt and equity investments with very low fees.
I’ve invested in peer loans for years but am shifting more of my money to my peer lending investing strategies. Peer loans are debt obligations so they don’t rely on future corporate earnings for a return. They are unsecured loans to individual borrowers but the best rated loans are to people with excellent credit scores and stable annual income. Defaults may creep up in a recession but many of these borrowers aren’t going to ruin their credit score by not paying a small personal loan.
I’ve been investing on Lending Club because it has the most loans available and returns have been high. I average around 10% annual return but may shift to less risky loans for a little lower return but more safety. Even on the safest loans, you can still earn a 5% to 7% return and protect your investments from high stock prices.
I’m also investing more in traditional bonds through exchange traded funds (ETFs). These are investments that hold bonds but trade like stocks so you don’t have the high fees as with buying individual bonds.
Bond investing is the corporate side of peer loan investing. While peer loans are made to individuals, bonds are loans to multi-billion dollar companies. They’re safer than peer loans but also offer much lower returns, between 3% to 5% a year.
Best Stocks to Buy when Everything is Expensive
There’s nothing wrong with just sitting out the stock market when prices are high or investing in other assets. It’s tough when your friends are bragging about the hot stock they found and made double-digit returns but you’ll be better off when the market takes a nose dive.
You’ll still want to keep some money in stocks but that doesn’t mean you have to be at risk in the most expensive stocks either.
Just like you can rebalance your money in safer asset classes, you can also shift your money into cheaper stocks. Part of this is understanding which stock sectors and industries have not risen as much as others and which will be safer in a recession.
The table here shows the gain in 10 sectors and the stock market over the last five years. Stocks in energy, real estate, materials and utilities have all lagged behind the rest of the market.
Stocks of utility companies and real estate firms are not expected to post gains similar to other sectors so the gap isn’t quite as big as it appears but there is still good value to be found in these lagging areas.
Besides just looking at which sectors have not risen as fast, you should also look at fundamentals like price-to-earnings, cash flows and other metrics. You don’t have to be a full-time analyst to use a few simple rules for picking stocks.
Most likely, if you’ve been investing for the last few years, you have more money in some of the runaway sectors like financials and healthcare. When stock prices get too high, it makes sense to rebalance your stock portfolio through selling some sectors and buying others.
I’ve got no crystal ball and this stock market has continued to surprise me. I’ve missed out on some of the increase over the last couple of months as I shifted to other assets but sleep well at night knowing that I’m protected when the eventual crash does come. Stocks prices are high by almost any measure and you don’t have to keep investing with the rest of the herd. Take this opportunity to invest in other asset classes and protect your portfolio.