Only six months after the global pandemic and nationwide shutdown began, the stock market has reached new record highs. This steep climb has occurred despite ongoing economic, market, and policy uncertainty and is further evidence that investors who are able to stay disciplined and invested, rather than overreact to short-term news, are more likely to achieve their financial goals.
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Market and Economic Fundamentals Matter Most
Perhaps the most important principle for disciplined investing is to focus on economic and market fundamentals rather than day-to-day price changes. This has been difficult to do given all of the unknowns surrounding the COVID-19 crisis and the government response. For instance, it’s still unclear when another round of economic stimulus will be passed by Congress, whether those cities and states facing an uptick in coronavirus cases will re-open soon, and how new trends in retail investing will affect individual stocks and the market as a whole.
These uncertainties have also made it difficult to gauge whether the stock market is cheap or expensive. Over long timeframes, valuations are possibly the best tools investors have to judge stock market opportunities. This is because buying the stock market when valuations are cheap means that you’re paying less for each dollar of earnings – or whichever fundamental measure you prefer. Investors who are willing and able to do so when others aren’t are often rewarded in the years and decades ahead.
Stock Valuations May Be Elevated
At the moment, not only has the market rebounded significantly, but the lack of clarity around corporate earnings has meant that valuations for the overall stock market are elevated. The “Shiller P/E ratio” for example, which measure the stock market’s price to earnings while also adjusting for inflation, is close to cycle highs. While this can change quickly if there is another episode of market volatility or if the economy recovers faster than expected, this suggests that the stock market is not cheap at the moment, per se.
In the chart below, the Shiller P/E ratio – also known as the cyclically-adjusted P/E ratio – measures the price-to-earnings of the stock market on an inflation-adjusted basis. This helps investors gauge how cheap or expensive the stock market is over time.
Chart 1: The Shiller P/E ratio – aka the cyclically-adjusted P/E ratio
However, the traditional Shiller P/E only applies to the overall market at a time when different parts of the U.S. stock market are valued differently. For instance, large-cap growth stocks have outpaced other parts of the market resulting in significantly higher valuations. This is partly because many tech, healthcare, and online retail stocks that have fared well during the crisis belong to this group.
Investors Are Paying a Premium for Growth Stocks vs. Value Stocks
The chart below shows the price-to-book ratios for growth and value stocks. Investors are paying a significant premium for growth stocks over value stocks at the moment.
Chart 2: Price-to-book ratios for growth and value stocks
Seek Attractive, Undervalued Areas of the Market
As is always the case, there are no guarantees that earnings projections or valuation levels will predict returns over the next few months or even years. There may be good reasons to invest in higher-valued investment. However, over long periods of time, adjusting portfolios in a disciplined way toward attractive areas that are under-valued by the market, and away from ones that are over-valued, has been one of the key principles to achieving long-term investment success.
With the overall stock market near record highs and with valuations at elevated levels, it’s more important than ever for investors to stay disciplined and avoid complacency.