Stocks are Expensive. So What Now?

If you don’t know U.S. stocks are expensive right now then you’ve done a very good job of avoiding the financial news media as well as social media and perhaps your investment savvy friends too. Expensive stock valuation levels don’t necessarily tell us much. For example, they don’t provide us with any sense of when valuations are going to get cheaper. However, they generally are a fairly good indicator of subsequent return and drawdown expectations. Using today’s valuation levels as a starting point, we can infer the following relative to lower valuation level starting points:

  1. Future returns will likely be substantially lower – Most return forecasts for the next 3, 5, and 7 years I’ve seen aren’t too encouraging. Of course, they are forecasts and are subject to error but history has shown that “buying high” usually leads to lower subsequent returns, especially when compared to “buying low”.
  2. Future drawdowns will likely be meaningfully higher – I recently saw a Ned Davis chart that showed the average three year drawdown from valuation levels similar to where we are today to be 18%, on average, with over 50% being the worst occurrence. I don’t know when the 50% drawdown occurred and I don’t know the range of outcomes but suffice it to say that an 18% drawdown over the next three years wouldn’t be very comfortable for most of us. Many would likely get shaken out at that point, most likely at the worst possible time (i.e., at or near the lows).

Investing in an environment where future returns are expected to be substantially lower than they have been recently and where future drawdowns are likely to be substantially higher is no fun at all. What’s worked over the past several years likely isn’t going to work going forward and what hasn’t worked may actually start to work. Active management has come under heavy scrutiny in recent years and rightfully so. However, moving forward adaptive asset allocation is likely going to be one of your best friends.