As the economy shifts from recovery to expansion, one challenge for investors continues to be the high level of valuations.
What is valuation?
Valuation is the analytical process of determining the current (or projected) worth of an asset or a company.
Keep your eye on valuations, not prices
In the long run, valuations may be investors’ best north star when navigating financial markets. This is because they’re highly correlated with long-run portfolio returns — i.e., buying when the market is cheap improves the odds of success and vice versa.
Prices can rise over long periods of time, just as they have for the US stock market over the past century, despite bear markets and short-term corrections. Comparing prices today to previous peaks and troughs doesn’t consider differences between these time periods. Valuations, on the other hand, “normalize” prices by some important measure such as sales, earnings, or cash flow. This adjustment makes prices more comparable over time to determine whether an asset class, sector, or individual investment is attractive.
Chart: The Shiller Price-to-Earnings ratio is based on the price of the S&P 500 compared to inflation-adjusted earnings over the past ten years. It’s at the highest levels since the dot-com bust.
Sources: Clearnomics, Standard & Poor’s, Robert Shiller
Today, various measures of value are at or near all-time highs not just for publicly traded stocks, but across a variety of asset classes. This is because the bull market has boosted prices faster than fundamentals have improved over the past year. (Fundamentals are the basic qualitative and quantitative information that contributes to the financial or economic well-being of an asset or company and their subsequent financial valuations. )
The Shiller Price-to-Earnings ratio, for instance, is elevated at 38x. This same pattern can be found across a wide variety of valuations measures, from price-to-sales to dividend yields. Across asset classes, especially public stocks, there are very few areas that are “cheap” in absolute terms today.
Why you probably shouldn’t rush to overhaul your portfolio
While investors should be aware of these facts and may find it prudent to make some portfolio adjustments, there are a few reasons investors shouldn’t completely overhaul their plans.
- Valuations do not predict short-term market behavior. While valuations are helpful tools for evaluating the attractiveness of investments, they do not predict market behavior in the short run. Markets can continue to rise or fall regardless of valuations for long periods of time, especially during the earlier stages of a bull market when the underlying trends are positive.
- Why valuations are high matters. While prices have certainly risen, valuations such as P/E’s are elevated because fundamentals are still catching up. As earnings accelerate, P/E’s can moderate to more reasonable levels.
- Staying diversified is key. In an environment in which all asset classes are increasingly expensive and the value of cash is eroding due to inflation, staying diversified is still the best approach for long-term investors. Including a variety of asset classes (including fixed income and international stocks) can still help improve returns and help smooth out market ups and downs even if their valuations are also above average.
Where do valuations go from here?
Where valuations go from here will be important for the direction of long-run returns. However, investors should continue to stay invested and diversified as the cycle shifts from a recovery phase to an expansionary one.
Put your investing on autopilot
It’s generally best to avoid moving your money in and out of the market to try and capture the performance highs and avoid the lows. That’s called market timing, and it’s extremely risky. Instead, consider setting up an automatic investing plan. You’ll invest a set dollar amount at regular intervals, regardless of market swings. It’s a nearly effortless way to consistently invest money for your goals. And in the end, you’ll end up buying the average price of an investment, which is exactly what you’d want to achieve in the long run. Remember, investing even small amounts can really add up over time.
Get a portfolio built to go the distance — in every economic condition
It’s generally better to stay focused on your long-term financial goals rather than daily market movements. Check out MoneyLion’s fully managed portfolios. They’re built by investment professionals to help navigate the markets whatever the weather — they are diversified across different asset classes and investment types to help smooth the investing ride, with no asset-based management fees or minimums.
This material, as well as the insights and data within, have been provided to MoneyLion by Clearnomics, Inc.
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