Dollars & Sense

Are Stocks Too Expensive?

Investors are more optimistic than in past years about the anticipation of lower tax rates.
Kate Warne, December 2017
Posted

Investors are more optimistic than in the past few years, due to better global economic growth and the anticipation of lower tax rates. As a result, stocks have reached many all-time records, supported by double-digit earnings growth for the S&P 500, better revenue growth and still-low interest rates.

Low volatility has lasted longer than many expected, but pullback predictions have increased. To prepare for a possible pullback, add fixed-income investments where appropriate. Bond prices frequently rise when stocks drop, and that relationship can help reduce your portfolio’s volatility.

How high is too high?

Over time, the stock market has reached new records, powered by economic and earnings growth. The domestic economy is picking up speed, helped by improving growth in the rest of the world, and company earnings have benefited from better sales and still-low interest rates. That’s why adding a mix of large-, mid- and small-cap U.S. equities as well as international equity investments is reccommended.

But valuations for U.S. stocks are also near all-time highs when you compare stock prices to earnings. Based on many valuation measures, stocks have been fairly expensive but this doesn’t mean stocks have gotten too high or you should sell now.

Remember, above-average valuations:

• Aren’t a sign of future volatility: Valuations haven’t been helpful in predicting short-term market moves in the past. Pullbacks of 10 percent or more have happened almost every year, regardless of whether valuations were high or low.

• Are followed by lower long-term returns: High valuations have frequently been followed by below-average stock returns.

Why add fixed income?

This extended period of extremely low interest rates worldwide has led some to worry about the risks of owning bonds. The Fed is expected to start reducing its bond holdings and keep raising short-term rates slowly and hesitantly as long as inflation doesn’t rise sharply and the economy grows modestly. Slow rate increases mean bonds can continue to provide income and reduce portfolio volatility as they’ve done in the past.

Expect pullbacks

Every year since 1970, stocks have experienced some sort of decline. Smart investors realize that such pullbacks are frequent, not a reason for concern, and can offer opportunities to add attractive investments at lower prices.

Kate Warne, PhD, is an investment strategist at Edward Jones.

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