Are Equities Overvalued?

In last week’s blog, we reviewed the fixed income market and discussed how we are positioned for the year ahead.  Today, we will turn our attention to the equity portion of our portfolios.  Perhaps the top question on most investors’ minds is whether the 5-year bull market can continue in 2015.  At this point, are equities overvalued or do they still have room to run?

I don’t think it’s useful to try to make predictions about what the market will do in the near future, but I’m certainly interested in understanding what risks we face and what areas may offer the best value for our Good Life Wealth model portfolios.  We use a “Core + Satellite” approach which holds low-cost index funds as long-term “Core” positions, and tactically selects “Satellite” funds which we believe may enhance the portfolio over the medium-term (12-months to a couple of years).

The US stock market was a top performer globally in 2014.  The S&P 500 Index was up over 13% for the year, and US REITs (Real Estate Investment Trusts) returned 30%.  Those are remarkable numbers, especially on the heels of a 32% return for the S&P in 2013.  With six years in a row of positive returns, valuations have increased noticeably for US stocks.  The S&P now has a forward P/E (Price/Earnings ratio) of 18, slightly above the long term average of 15-16.

While US stocks are no longer cheap, that doesn’t automatically mean that the party is over.  With a strong dollar, foreign investors are continuing to buy US equities (and enjoyed a greater than 13% gain in 2014, in their local currency).  The US economic recovery is ahead of Europe, where growth remains elusive and structural challenges are firmly in place.   Compared to many of the Emerging Market countries, the US economy is very stable.  Emerging economies face a number of economic and political issues, and struggle with declining energy prices, often their largest export.

US Stocks remain the most sought-after.  While today’s P/E is above average, “average” is not a ceiling.  Bull Markets can certainly exceed the average P/E for an extended period.  And given today’s unprecedented low bond yields, it’s tough to make a comparison to past stock markets; equities are the only place we can hope to find growth.  Current valuations are not in bubble territory, but it seems prudent to set lower expectations for 2015 than what we achieved in the previous five years.  And of course, stocks do not only go up; there are any number of possible events which could cause stocks to drop in 2015.

Given the current strength of the US market, you might wonder why we own foreign stocks at all.  They certainly were a drag on performance in 2014.  In Behavioral Finance, there is a cognitive error called “recency bias”, which means that our brains tend to automatically overweight our most recent experiences.  For example, if we did a coin-toss  and came up with “heads” four times in a row, we’d be more likely to bet that the fifth toss would also be heads, even though statistically, the odds remain 50/50 for heads or tails.

Checking valuations is a important step to avoid making these types of mistakes.  Looking at the current markets, Foreign Developed Stocks do indeed have better value than US stocks, with a P/E of 15.5 versus 18.  And Emerging Market stocks, which were expensive a few short years ago, now trade at an attractive P/E of 13.  We cannot simply look at which stocks are performing best to create an optimal portfolio allocation.  Diversification remains best not just because we don’t know what will happen next year, but because we want to buy tomorrow’s top performers when they are on sale today.

Our greatest tool then is rebalancing, which trims the positions which have soared (and become expensive), to purchase the laggards (which have often become cheap).  So we’re making very few changes to the models for 2015, because we want to own what is cheap and want to avoid buying more of what is expensive, even if it does continue to work.  We will slightly reduce International Small Cap, and add the proceeds to US Large Cap Value.  US Small Cap has become quite expensive, but small cap value now trades at a bit of a discount (or is less over-valued, perhaps), so that is another shift we will make this year.

Each year, I do an in-depth review of our portfolio models and I always find the process interesting and worthwhile.  This year, looking at relative valuations in equities reminds me that our best path is to remain diversified, even if owning out-of-favor categories appears to be contrarian in the short-term.