Tag Archives: Retirement planning

Understanding Current Market Valuations and Risks

After three quarters of 2024, the S&P 500 is up 20.81%, and +34.38% over the past 12 months (Morningstar). Portfolios that include US small and mid-cap stocks, and international, have underperformed the large-cap US market. Price multiples over twenty times earnings are historically high.

Current valuations are based on optimistic assumptions. The risks seem skewed to the downside for the S&P 500 index, but the risk is concentrated in the 10 largest stocks. Although a large decline is not inevitable and might not last long, it is something to be prepared for.

On the positive side, not one of the four primary recession indicators, including residential investment as a % of GDP, light vehicle sales, business fixed investment as a % of GDP, and total business inventory/sales ratio, is warning of recession.

The Fed recently cut interest rates for the first time this cycle because inflation is declining. That is good for stock valuations as long as economic growth remains strong. The labor market will be a key indicator to show whether inflation is declining due to a weakening economy or if underlying economic growth remains strong. Market valuation hangs in the balance.

The election circus, port strike, and geopolitical chaos are ever-present risks, but there should eventually be an upside to them.

Investing involves risk, including possible loss of principle. Past performance does not guarantee future performance.

How High Is Too High?


The S&P 500 logged a stellar first quarter of 2024, rising just over 10% in 3 months. Moreover, it has gained more than 28% since the October low, just five months ago. It is likely that something will happen to trigger a sell-off from these levels. Trying to time a correction is not a good strategy. Sometimes momentum begets momentum. We could see another 10% rise before a reversal. The price of market returns is volatility. It might help to view part of the recent gains as “cushion” to offset a correction.

We’ve Come a Long Way

I am attempting to lean into rising risk by delaying new cash deployments and allocating new funds to value oriented positions. On the positive side, the Morningstar Market Valuation indicator suggests that the market is only 4% overvalued. That does not suggest a change in strategy, but I see significant parts of the S&P 500 trading at valuations that stretch my imagination.


Valuation and concentration risks are becoming elevated, but a correction is not inevitable in the near term. The key factor, as usual, is earnings and cash flow growth that provide fundamental support for market valuations. Another moderate risk factor would be fewer or delayed rate cuts. More impactful, but less likely factors include an inflation rebound or an earnings slowdown.

The overall outlook remains positive based on the four supporting themes including:

  1. Stable growth
  2. Falling inflation
  3. Impending Fed rate cuts
  4. AI enthusiasm

I will be watching these developments.

Past performance does not indicate future performance. Investing involves risk, including loss of investing principal.

Taking Stock of the Rally

The S&P 500 finished 2023 up 24.23% (Morningstar data source). Even though the index was positive throughout the year, the volatility was challenging.

(SPY is an ETF that tracks the S&P 500. Graph illustrates SPY performance for 2023)

Expectations of lower interest rates and a soft or no landing drove the rally during the past two months. Four important assumptions underpin current expectations.

The market consensus supporting valuations includes:
1. Six rate cuts for a 1.5% cut in the discount rate, bringing the year-end fed funds rate below 4%.
2. No economic slowdown/sustained earnings growth
3. Geopolitical conflicts do not worsen.
4. Domestic political situation does not deteriorate.

These assumptions are not necessarily wrong, but they may be optimistic. The issue is how events surrounding these issues unfold.

Other observations to keep in mind as 2024 kicks off. The Magnificent 7 large cap tech stocks that comprise about 28% of the market cap weighted index (as of 12/19/2023) overshadow the S&P 500 performance. Using the S&P 500 as a benchmark is problematic in that it skews the risk/return of the broader market. I expect the market to broaden as the rest of the market plays catchup and large cap tech cools.

Investing involves risk, including the possible loss of principal. Past experience does not predict future returns. I could go and and list all the other boilerplate language that regulators like to see, but I’ll stop here. If you have any questions about anthing inferred from this post, please consult with me or another investment advisor.

And So the 4th Quarter Begins

The stock market fear gage, the VIX, is flashing extreme pessimism. If you follow the news flow, it is easy to see why. It’s a constant barrage of negativity. It’s important to note that crises and the stock market have coexisted for decades. Crises come and go, while the stock market has always been volatile, yet sustains a positive trend.

Near-term indications suggest that the market is challenged by the Fed interest rate policy but appears reasonably valued all things considered.

My favorite bottom-up indicator, the Morningstar Market Valuation chart, puts the US market at 91% of fair value on 9/30/23, suggesting slight undervaluation. On a deeper level, growth is slowing, but it is very debatable how much it will slow. For now, it appears that the answer is “not too much.”

Part of the reason the market pulled back from its recent high at the beginning of August is that the Fed signaled that it is likely to keep rates higher for longer. Higher yields translate into lower stock price multiples. Ultimately this will reverse when the Fed sees the threat of persistent inflation above target diminishing.

In the absence of an upside catalyst, I expect the market to remain rangebound (S&P 500 between 4,220–4,560) until either the positive scenario occurs with the economy’s slowing stops, the Fed becomes dovish, and disinflation proves successful. On the downside, if either of these factors deteriorates, the market could break to the downside.

This morning’s job report (Tuesday, October 3, 2023) sent interest rates higher. Accordingly, stocks dropped. The knee jerk reaction to a data point illustrates the market’s myopia in seeing the trees instead of peering through the forest. Every data point is extrapolated far into the future when we’re pretty sure that won’t be the case. That suggests the long-term outlook just went up by the amount of today’s decline.

A Chat GPT forest

I’ll also comment about Congressional dysfunction after this past weekend’s drama. A Government that can’t govern is not helpful given the fiscal state of this country. It can only create uncertainty in the Treasury market. Stocks will not go up with interest rates increasing from this level. Let’s hope Congress gets its act together sooner than later.

Last quarter I noted that the market “appears to be approaching fair value” after being up 15.91% in the first half of the year. The 3rd quarter pullback was not surprising.

The bottom line is that the S&P 500 went up 13.03% YTD through the 3rd quarter according to Morningstar. The 4th quarter should be interesting.

Investing involves risk, including loss of principal. Past performance is not indicative of future returns.

Recession Ahead?

Despite a banking crisis, rising interest rates, the indictment of a former president, et al., the S&P 500 finished the 1Q23 with a 7.03% gain. However, within the U.S. Market, growth stocks were up 14.79% and value was up only .18%, according to Morningstar. Despite this quarter’s gains, the Morningstar Market Valuation estimate puts the market at 92% of fair value.

The Fed kept interest rates too low for too long. There’s plenty of blame for both sides of the aisle in Congress too. While inefficiencies need to be purged from the system, politicians try to address the suffering at the individual level of those directly impacted when marginally profitable businesses are forced to close.

The banking problems that surfaced in March 2023 are one of the unintended consequences of Fed policy. Low interest rates incentivized banks to stretch for yield by buying long duration bonds that exposed their asset portfolios to excessive interest rate risk. When Silicon Valley Bank faltered, the whole banking system became suspect, and we saw a contagion effect with depositors pulling funds from similar banks. The Government intervened by extending FDIC insurance.

It is unreasonable to expect that 10+ years of easy money will not create some financial moral hazard. Now that we’re getting off the sauce, we’ll see who has been swimming naked. I expect continued volatility until the second half of the year. Getting past the peak interest rate question, lower inflation, the regional bank solvency question will likely result in better equity markets by the end of the year.

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

Zoom Out

Time brings perspective, and now might be a good time to reflect on that. This month has been exhausting for investors. The damage is relative. If you invested last month and need to sell now, you might have a problem. But if you are a prudent investor with a 3 to 5-year time horizon, I think you’ll be just fine. This is normal volatility. For perspective, consider the following views of the S&P 500.

First, consider how you feel. The chart below shows a 5-day view. Pretty lousy, huh?

Next, we’ll zoom out to a 3-month view. Not much better.

Now let’s see how the index has done over the past 12 months.

As the above chart shows, it has been like a roller coaster, but it is still positive. Now let’s zoom out to the 2-year view. I think most investors would be pleased with the 29% gain they would have received from the SPY, an ETF that tracks the total return of the S&P 500 including dividends. These charts show just the index, excluding dividends.

Finally, here’s the 5-year view that shows the accumulation of retained earnings created by millions of people going to work every day. This is more like it. Now our scary stock market looks more like a not so uncommon speed bump along the way to greater prosperity.

Exhale and have a nice day!

Charts from Yahoo Finance. Past results are not guaranteed. Investing involves risk, including loss of principal.

Recession Strategy

I am seeing a lot of ink about how to prepare for the next recession. Clients want to know what we’re doing to prepare. Investment companies are asking me which funds I think are best for the next downturn.

The real issue is not how deep the correction will be. The real concern is the duration of the decline. How long will it take to get back to even? The problem is not that the stock market will go down. The real problem is if you need to sell stock when valuations are low to fund current living expenses. That converts a temporary loss of capital into a permanent loss of capital.

I’ve been investing since the 1970’s. My education and career have focused on economics and finance. What have I learned? In my view, valuation risk is easy to observe, but timing a correction is still difficult. I recognized that the S&P 500 was overvalued in 1998, but it doubled again before getting cut in half in 2000. I observed in 1999 that the market would either go down by 50% or trade sideways for 10 years while earnings caught up. I had no idea I would be right on both counts. Despite that, a diversified portfolio including small cap, international and bonds fared much better.

Systemic risk is harder to recognize. I didn’t see the 2008 crisis coming. But it really wasn’t a stretch to see what asset class was overvalued, i.e. real estate. But then you needed to understand that banks and credit agencies were operating in a corrupt system underwritten by government agencies, that mortgage defaults would create a downward spiral as underwater homeowners defaulted, forcing prices ever lower.

We accept the unpredictable nature of corrections, and that unique circumstances precipitate them. Today, credit seems to be the most mispriced asset class, driven by government intervention. But bonds are math, and the effects of normalization should be more moderate than a speculative equity correction unless there are forces involving leverage that are not on my radar – like the mortgage security market. Still, the recovery of the past 10 years made staying invested worthwhile. We just needed to hedge for liquidity needs over the next 3 to 5 years to emerge unscathed.

What does all this mean? I believe that a heightened level of concern about the next recession or correction is healthy. As investors de-risk portfolios, valuations will be earnings driven, and that’s a good thing for fundamental investors. Certainly war, policy mistakes, and scandal can impact markets, but these events have nothing to do with the duration of a market expansion. They can happen at any time, so why should the risk seem greater now?

My favored strategy continues to be the bucket approach. One of the key benefits of a financial plan is that it identifies anticipated liquidity needs. Given that most market downturns are resolved in less than 3 to 5 years, it is prudent to establish reserves equal to your liquidity needs in something with less risk than the stock market. Accepting risk in the short-term is gambling, and gambling with what you can’t afford to lose is a bad idea. Investors have time on their side as companies continue building wealth even while the market doesn’t always correlate with that. Be prepared, be vigilant, and stay the course until fundamentals indicate otherwise.

“WE’RE BUYING STOCKS THIS MORNING, AND I’D RATHER BUY THEM CHEAPER, BUT I’VE BEEN BUYING STOCKS SINCE MARCH 11th, 1942, AND I REALLY, I BOUGHT THEM UNDER EVERY PRESIDENT, SEVEN REPUBLICANS, SEVEN DEMOCRATS I’VE BOUGHT THEM QUARTER AFTER QUARTER. SOME OF THE BUYS WERE TERRIFIC, SOME OF THEM WEREN’T AT SUCH GOOD TIMES AND I DON’T KNOW WHEN TO BUY STOCKS, BUT I KNOW WHETHER TO BUY STOCKS, AND ASSUMING YOU’RE GOING TO HOLD THEM, WOULDN’T YOU RATHER OWN AN INTEREST IN A VARIETY OF GREAT BUSINESSES THAN HAVE A PIECE OF PAPER THAT’S GOING TO PAY YOU 3% IN 30 YEARS OR SHORT TERM DEPOSIT THAT PAYS YOU 2% OF THE SORT.” WARREN BUFFETT, August 30, 2018

Investing involves risk, including loss of principal. Past results do not guarantee future results.

How High is too High?

What difference 3 quarters makes! The S&P 500 is up 14.2% year-to-date, and 4.5% in the 3rd quarter. After the initial Trump rally, nearly everyone, myself included, expected some type of correction. The market continues to brush-off geopolitical concerns. While North Korea might make for scary headlines, the markets are voting that it is unlikely to have a real adverse impact on corporate earnings.

Stocks sell at a multiple of current earnings. The multiple depends on how the market views future earnings. The question of how high the market can go is to ask how much the businesses in the index are worth.

The good news is that there really is not a limit. If a working man puts $5 in a jar every day and does not die, how much is the jar worth? I can calculate how much you should pay for this man’s savings today, but over time, the answer is unlimited.

This is not to suggest the market can’t be overvalued because it can be. Rather, there is no number that represents an absolute limit. I believe the market is moving higher because we have an administration that is pro-business and focused on tax reform. Fiscal spending is also becoming a factor.

There is room for further gains, but corrections will happen. Volatility is the price of equity returns, and that’s been missing for the most part. Stay the course but plan for liquidity.

Managing Volatility in Growth Portfolios

In normal times you might own bonds for either of two reasons.  You might enjoy the regular income from interest payments, or you might own them for the stability they add to an equity portfolio.

Neither of those reasons carry the usual appeal with today’s ultra-low interest rates.  If you’re counting on bonds for income, you are going to need to own a lot more bonds.  While bonds add stability, the total return will be reduced when interest rates eventually move to higher, normal levels.  Neither reason is particularly compelling these days, although the stability factor is more compelling given stability in a quick equity correction.

The bond market is not uniform.  Some parts of the bond market have less exposure to interest rate risk.  Additionally, the proliferation of alternative strategies offers investors a wide array of tools for managing risk in today’s macro driven investment climate.

Much has been written about various types of risk, and that is not the focus of this essay.  My purpose is to explain an approach to managing equity market risk in the current low-interest rate environment.

Liquidity is important.  Let’s take the case of the Brexit induced market decline that began last Friday.  Over two days the Dow lost about 900 points as stunned markets went into “sell first, ask questions later” mode.  If you believed, as I did, that the world economy was not poised for mass suicide, and that cooler heads would prevail as hysteria faded, you might have been inclined to sell some of those bond positions to buy equities at distressed prices.

If those bond or alternative positions were in mutual funds, the cash would not be available for trading until the next day.  Using margin is not a bad strategy, since you can execute a purchase locking the price before the bond fund sale is complete.  If you wait until the next day, the price could be higher.  It could have gone lower too, but that’s speculation.  If you want to control the trade, you want to make timely buy and sell decisions.

Using hedge positions in ETF format eliminates the liquidity problem.  Unfortunately, many of the better bond funds and hedge strategies are based on active management, and hence not available in ETF format.  There is no perfect solution.  If the main objective is performance relative to a benchmark, for a fixed/alternative portfolio component, then the mutual fund liquidity problem can be overcome with judicious use of margin.  If the objective is to hedge a richly valued market in a world fraught with macro risk, then bond sector ETF’s can fit the bill.

Then again, in a rich market, cash is an attractive asset class.  To paraphrase Charlie Munger, a good way to get rich is to put $5 million in a checking account and wait for a good crisis.