How Market Valuation Should Be Influencing Your Portfolio

The topic of high valuations remain at the forefront of many investors’ minds with the cyclically adjusted P/E on U.S. stocks still just over 30 currently and having only been higher twice, in 1929 and in 2000. As one might expect, investing in expensive markets doesn’t typically have a big payoff, so when we were recently contacted by a journalist working on a story about investing in an overvalued market we were happy to share our insight. What follows are our responses to the questions posed about the role market valuation has in a portfolio.

At what point would an overvalued market reach a tipping point? In other words, when should investors begin to worry, if at all?
While we certainly agree that the U.S. stock market is overvalued, and broadly so, valuation in and of itself isn’t sufficient to precipitate change. Starting point in terms of valuation is a great predictor of long term returns, but is silent as to timing. The takeaway for investors is that there are better times to take risk and worse times, and given the slim margin for error that exists because of the overvalued conditions, now is not the time to be overly courageous, even if the catalyst for market deterioration remains elusive.

How can investors identify sections of their portfolio that may be overvalued?
Valuation is a function of the outlook for growth, the level and likely path of interest rates, and sentiment, all of which are difficult to forecast with any accuracy. Further, given the paltry yields on investment grade debt, skinny spreads on high yield debt, and high price-to-earnings and price-to-sales measures on equities, the question seems to be, what isn’t overvalued? Generally speaking, we think that question leads investors overseas to both developed and emerging markets. If investors are hesitant to make geographical calls, then allocating to global strategies can make a lot of sense, as global managers can make the necessary relative value decisions and allocate appropriately, reducing the burden on investors.

What’s the best strategy to balance out a portfolio when there are concerns about overvaluation? For example, is moving more of your investments into cash a good way to downplay exposure to volatility? What about bonds or international stocks? Are those things investors should be looking to in the current market?
Because valuation has such a poor track record of predicting short to medium term returns, and because the opportunity cost of sitting on cash can be so high, especially when cash is generating a negative real rate of return, as is the case at present, we think investors need to get a bit more creative, expanding beyond the typical 60/40 stock/bond portfolio.

For one, they should be considering strategies that can capture much of the upside should markets continue to run, but with substantially less risk. One potential strategy that fits the bill is long/short equity. Further, going from the specific to the general, investors should be diversifying broadly across equity and fixed income markets, reducing their home country bias, and they should be incorporating true diversifiers, like managed futures strategies. Lastly, within the long-only equity component of a portfolio, investors should choose strategies with proven downside protection (i.e., look for approaches with good downside capture ratios).

How important is your time horizon when choosing the best investment strategy in a market environment like the one we’re facing now?
Time horizon is always of critical importance, because that variable, along with financial wherewithal and emotional composure should shape the overall risk exposure of a portfolio. It can take many years to recoup a big loss, thus robbing investors of the time to compound their money, which for many, especially those close to retirement, can be life altering.

What’s the one thing an investor shouldn’t do if they’re worried about market overvaluation?
The one thing investors should avoid doing is making wholesale risk on / risk off decisions based on what is likely no more than a hunch about market direction. Reducing risk if your financial situation, your emotional composition, or your time horizon dictates is sensible, but thoughtful portfolio construction will likely lead to more favorable results than will timing decisions.

 

Read our related blog on our recent trip to Camp Kotok, Wisdom in the Woods