Higher Still?

The good news is the stock market had another great year. The S&P 500 was up 26.84% in 2021. That is on top of the 16.26% in 2020 and 28.88% in 2019. That’s quite a run, even if it started on the back of a down year in 2018.

On the other hand, the S&P 500 is overvalued by most standards. By comparison, the Vanguard Total International Stock ETF, was up only 9%. More telling is the price to earnings ratio. The S&P 500 trades for 21.15 times earnings while the non-US Vanguard ETF, VXUS, trades for 13.2 times earnings, a 37.6% relative discount. (based on Morningstar data)

If you have a diversified portfolio, your investor returns have lagged the S&P 500, where performance was driven by large cap tech stocks.

When will things reverse? I cannot say when, but I can imagine how it might happen. In the words of John Maynard Keynes, “The market can stay irrational longer than you can stay solvent,” the timing is unpredictable. The predictable factor is that it will likely require a catalyst to put the market on sounder footing.

Potential catalysts include:

  1. A worsening COVID scenario with new variants and higher case counts
  2. Persistently high inflation
  3. A Fed policy mistake (watching the yield spread between 2- and 10-year Treasuries)
  4. Slowing earnings growth as Fed stimulus recedes.

If one or more of these events occur and earnings expectations decline, I think a 20% correction would be reasonable. The math of a 4% decline in earnings and an 18 P/E multiple fits such a scenario. But things can go right too, so timing a correction is not a sound strategy.

The prudent course is to plan for liquidity needs and maintain a diversified portfolio and perhaps more cash than usual. Think of cash as an option to buy stocks cheaper if they go down. A 20% correction is not fun, but it is to be expected. When it happens, a little cash goes a long way. One more thing… when the market goes down 20%, you only lose 20% if you sell low. The bigger issue is how long it takes to recover. It has always recovered. Whatever you do, don’t sell low