"One of the funny things about the stock market is that one man buys, another sells, and they both think they are astute."
- William Feather
Although some investors disagree that the financial markets are overvalued, what if an investor believes they are? Is it ever appropriate for a long-term investor to become more defensive with his or her investments? Many investors remember the pain of watching their investment accounts fall by 40%, 50% or 60% during the stock market downturns of 2000-2002 and 2008-2009. If an investor had foresight that the market was risky and due for a pullback would the wise course of action have been to lighten up on stocks and put that money elsewhere? What if we are at the same point today, on the precipice of another sharp decline in the stock market. If I sell some of my stock investments am I "timing" the market? And what if the market continues rising after my sale? Would that have been a mistake to sell?
There is no bell that goes off once a market has made a top and takes a trip downward, whether that's for a small 5% decline, a larger 10% one, a 20% "correction", or a 50% crash. Investors who don't have the stomach or the necessary time required to ride out those declines may not want to be so aggressively invested. That may be especially true after markets have seen great gains and are perhaps due for a fall. Even for long-term investors, market routs can take years for investors to become whole again. Those investing in the U.S. stock market, as measured by the S&P500 index, during the years of 1997-2000 would not see those investments show gains for more than five years. A similar result would await those investing during the 2004-2008 period who, after the market plunge of 2008, would not see positive returns for more than five years. For those investors getting into the market at the top in late 1999 and early 2000, they would not see their investments turn positive for 10 years.
Fast forward to early 2014 and there are indicators that the stock market isn't the bargain it was a few years ago and is now rather frothy and perhaps due for a pullback, correction, or yes, even possibly, a crash. For starters, when measured in time, the current bull market that began in March, 2009, is now nearly 5 years old, slightly longer than the average bull market length (58 months) over the past few decades. During these past five years, the U.S. stock market increased 170%, the largest increase in the last two decades with the only exception the "internet bubble" stock market of the late 1990s.
The ratio of the stock market's total market value to the size of country's economy (GDP) is now around 125%, which over the last 40 years is the highest it's been except, yes, the internet bubble stock market bubble of the 1990s. The mega-investor Warren Buffet has called this measure the "best single measure" of the stock market's value. Based on this indicator, anything over 115% is indicating a "significantly overvalued" stock market. And the market is currently quite a bit above that. Anecdotally, we are also seeing many signs of frothiness and bubble conditions in the stock market when we seem extremely high valuations (when using traditional metrics like price-earnings ratios) for stocks like Facebook, Twitter, Netflix, Amazon, and Priceline.
Comparing the relative values of stocks to bonds also does not seem to favor today's stock investors. A measure comparing stock values to bond values shows that the ratio of the stock market to the bond market is about as high as it was in early 2000 and mid-2007, which just happened to correspond to market tops and stock market declines that would each cut prices in half within two years. While bonds may not be a great value (more on this in a future article), compared to stocks they're a relative buy.
If we are at a similar overvaluation point in the stock market, such as those that existed in 1999 and 2007, is it appropriate for an investor to make any changes to her portfolio? Would it have been appropriate for the investor to sell some investments back in 1998 or 1999 as the market became increasingly frothy or in 2007 when warning signals of economic and financial difficulties were flashing red to almost anyone who cared to look?
An investor who decided that at those times she didn't really want to have, for example, her regular 70% allocation in stocks, but instead would move to about 50% stocks, was not really making a radical change and under the circumstances of large recent gains and an increasingly risky market, her action was probably rather prudent. You don't necessarily have to be a market "timer" to reallocate your investments, even in response to market conditions. Regular, occasional investment allocation is often appropriate and when done correctly often reduces the volatility of an investment portfolio.
The first step in possible portfolio reallocation is to look at how market conditions have changed the composition of your investment portfolio and whether your portfolio still matches up with your desired allocation. For example, let's assume that I intend my long-term investment allocation to be 50% stocks, 30% bonds and 20% cash. If when checking the values of my investments I see that I now have 70% stocks, 15% bonds and 15% cash, I should strongly consider moving some of my "winning" stock investments to cash and bonds. (This is assuming there are no tax consequences, if there are it's a more difficult decision and discussing the possibility with your tax advisor would probably be appropriate.) That is especially true with the stock market today, which at the very least, by traditional measures is not "cheap" any more.
By the way, reallocating to a less "aggressive" investment posture is not as important for some individuals depending on their assets, age and other factors. For example, everything else being equal, an investor with fewer assets and who is still regularly investing can afford to take a bit more risk and ride out possible declines in the stock market. I talk about this in more detail in my book Let Your Money Grow
What about if your investment allocation is pretty much the way you want it to be long-term? If I'm at 80% stocks but have been at that level for the past 5 years, is it prudent to decrease my risk now because I think the market is due for a pullback? As usual, that depends. Is worrying about a possible market decline keeping you up at night? Are you now too close to retirement or needing that money that you couldn't absorb a 30% or 40% loss and couldn't wait five years for the market to come back? In those cases, probably moving some of your stocks into less risky investments would be prudent. Again, think about and calculate the tax consequences. Taxes aren't the only thing, but they are an important one.
If you are aware the stock market is rather high, rather frothy, and the economy rather fragile, but are content to ride out any market declines, then the only task is to maintain that mental fortitude when and if the decline comes and you are tested. The worst situation is to think you are a long-term investor, a steep market decline tells you that you aren't, you sell your investments after the market has fallen, but then feel the need to get back in after the market has risen once again. As a whole, individual investors are not the best market timers (I also examine this in more detail in Let Your Money Grow), but success or failure mostly stems from an investor's mental attitude during market declines.
Over the past several years, investors have been given a gift, of higher prices, from the depths of a bear market to near record gains over the past five years. Investors who don't want to ride the same roller coaster again have the opportunity now to lessen that volatility. Other investors whose portfolios have shifted due to market gains can also reallocate to their desired allocation. And for those investors who are content to ride out the market without making any changes, they need to be honest about not only how they will respond to market declines, but how they will emotionally handle portfolio declines of 10%, 20% or 30%. If their emotions lead to pain, regret, inability to sleep at night and an increasing desire to sell as the market falls, they are too aggressively invested to handle the decline. If on the other hand, their emotional response to a stock market decline is one of mostly indifference because of a long-term commitment to indifference or even better, a welcoming of lower prices because it allows it allows them to buy up more shares of stock, then the stock market is the right place for them, whether the market is declining or not.