The world of investing can be a treacherous landscape, filled with pitfalls for the unwary. The Securities and Exchange Commission’s Rule 156 serves as a warning to investors, urging them to exercise caution and not to be reckless. A typical disclaimer found in nearly every financial document states:
“Past Performance Is Not Indicative of Future Results”
Unfortunately, this advice often falls on deaf ears. Many investors, including professionals, make careless decisions. What’s even more concerning is the glaring lack of guidance on how to make informed investment choices. Perhaps the omission stems from a desire to keep the market available to all, regardless of their understanding.
Indeed, without a clear grasp of market dynamics, past performance becomes a poor predictor of future returns. One year, the S&P 500 may rise by 10%; the next, it could jump by 20%. But soon after, the index might plummet by 50%—a shocking revelation for even the most seasoned market analysts.
Yet, most investors base their future expectations on past results. For example, your retirement advisor at Edward Jones might enthusiastically highlight that the S&P 500 has delivered an average annual return of approximately 8 percent over the last 60 years. They might follow this up with a visually appealing chart illustrating how much you need to save each month to achieve millionaire status by retirement.
However, this seemingly precise figure is misleading. While 8 percent does represent a long-term average return, averages can be deceptive. Assuming this rate without critical evaluation could leave you vulnerable to disappointment.
Achieving or exceeding that average requires either luck or thoughtful consideration of market conditions. Without these, you risk becoming just another casualty in the world of Wall Street investment. We will provide practical tips shortly on how to avoid this fate, but first, let’s explore some essential principles for sound investing.
Price Matters
Investment returns hinge on three factors: the price you pay, the sale price, and the cash flows generated (or expenses incurred) in between.
Among these, you have significant control over your buying and selling decisions. Ideally, you’ll aim to buy low and sell high, but many investors fall into the trap of buying high and selling low.
When analyzing the stock market as represented by the S&P 500, it’s crucial to distinguish its price from the corporate earnings or sales behind that price. Price alone lacks meaningful context; however, comparing it to earnings or sales helps gauge whether the market is overvalued, undervalued, or fairly priced.
Clearly, when the market is undervalued, buying is wise, and selling becomes prudent when the market is overvalued. Yet emotions often misguide us—fear can lead you to sell when prices are low, while unbridled greed may push you to buy during market highs.
At present, the S&P 500 is significantly overvalued. It is advisable to exercise caution, considering reallocating some of your funds—though not all—into cash or gold.
Here’s why…
Don’t Be Another Wall Street Chump
The Shiller Cyclically Adjusted Price Earnings (CAPE) ratio evaluates stock prices relative to their inflation-adjusted average earnings over the past decade. This approach provides a clearer long-term perspective, smoothing out year-to-year earnings fluctuations.
As of the market close on September 12, the CAPE ratio for the S&P 500 stands at 30.17, which is over 81% higher than its historical average since 1881. Such high CAPE values have been rare.
Notably, on May 3, the CAPE ratio reached 31.05—exceeding valuations seen just before the 1929 market crash. The only instances of higher CAPE ratios occurred during the late 1990s, just before the dot-com bust.
Clearly, the S&P 500 is extremely overvalued according to the CAPE ratio. However, for an even more precise measure of valuation, consider the MAPE ratio.
John Hussman, Ph.D., and President of Hussman Investment Trust, is well-regarded for his in-depth research into stock market valuations. His work includes the development of several metrics, including the Hussman Margin Adjusted Price Earnings (MAPE) ratio, which adjusts profit margins cyclically. Hussman found that the MAPE correlates better with subsequent ten-year returns than the CAPE.
The Hussman Market Comment for September indicates a MAPE of approximately 45. At this level, current market valuations surpass those seen in 1929, 2000, and 2007. The full article is highly informative, but one significant takeaway is:
“The steep losses of the S&P 500 in 2000-2002 and again in 2007-2009 were consistent with a century of historical experience. Given current market valuations, the prospect of yet another 10-12 year period of zero or negative returns for the S&P 500 would also be wholly consistent with a century of evidence.”
Essentially, investors in S&P 500 index funds might find their portfolios stagnant for years, perhaps not even surpassing current levels by 2030. Clearly, the entry price significantly influences your investment’s future.
Therefore, it’s imperative to avoid investing in the S&P 500 at such inflated valuations. Don’t become yet another Wall Street chump.
Sincerely,
MN Gordon
for Economic Prism
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