The Market Is Overvalued and the Bond Bull Market Is About to End

 

KEY TAKEAWAYS

  • Record high market valuations and a historically long bull market don’t necessarily mean a correction is imminent.
  • A typical bear market results in a 24 percent decline, but those “losses” only become realized if you sell out.
  • Don’t let emotion and media hype cloud your thinking during declines. Stick to your plan and consult your advisor.

 

The financial headlines have sounded the alarm bells about the stock market’s recent record highs and lofty valuations. The implication is that stocks are due for a dramatic pullback. It’s not only the record highs that have many investors spooked. Consider that it has been over eight years since the last bear market (they typically occur every four years), and the Dow Jones Industrial Average (DJIA) has more than tripled since its low of 6,547.05 on March 9, 2009. Sure, we’ve had plenty of volatility during the past eight years. Remember the intra-year loss of 19.4 percent in 2011? Remember the first four trading days of 2016 – the worst start ever to a new calendar year? Even so, we have not met the technical definition of a bear market, which many experts consider to be a loss of at least 20 percent that’s sustained for two months or more. Are we due for a bear market? Yes, but let’s keep a few things in perspective:

 

  1. Valuations may be high, but lofty valuations are not reliable predictors of stock market declines. What high valuations do indicate is that stock returns going forward may be less robust than their historical norms. Therefore, you should adjust your long-term planning to reflect the realities of the market and avoid making short-term adjustments based on mere speculation.
  2. On average, a bear market occurs every four years with an average decline of 24 percent. Those are the unavoidable facts about the risk you assume for the substantial rewards of investing in the market long-term. Remember that temporary losses resulting from a bear market only become realized if you sell out.
  3. Trying to time the sale of your stocks during the downturn and then investing on the market’s recovery is almost impossible. There are just too many emotions involved in this kind of market timing strategy. Even if you do sell at precisely the right time, you still need to figure out when to get back into the market. Otherwise, you have sums of cash sitting idle, earning you very little.

 

Back in March of 2009, there were very few headlines encouraging investors to buy into the market. It was mostly a time of depressing stories about the dismal state of our nation’s economy, job market, and financial situation.

The media and prognosticators make their living by crafting stories (not to mention headlines) that play into your emotions. Tapping into investor fear is how they get people to view and/or click-through to their stories. On the other hand, Warren Buffet, who is arguably the greatest investor of our time, regularly provides a more thoughtful and realistic evaluation of the stock market and our economy. In his latest newsletter to Berkshire Hathaway shareholders, Buffett wrote:

“America’s economic achievements have led to staggering profits for stockholders. During the 20th century the Dow-Jones Industrials advanced from 66 to 11,497, a 17,320 percent capital gain that was materially boosted by steadily increasing dividends. The trend continues: By yearend 2016, the index had advanced a further 72 percent, to 19,763.

American business – and consequently a basket of stocks – is virtually certain to be worth far more in the years ahead. Innovation, productivity gains, entrepreneurial spirit and an abundance of capital will see to that. Ever-present naysayers may prosper by marketing their gloomy forecasts. But heaven help them if they act on the nonsense they peddle.”

Keep in mind that Buffet is no blind optimist. He’s a well-grounded pragmatist who’s been through every imaginable market cycle. Given that backdrop, he also told his shareholders that:

“Many companies, of course, will fall behind, and some will fail. Winnowing of that sort is a product of market dynamism. Moreover, the years ahead will occasionally deliver major market declines – even panics – that will affect virtually all stocks. No one can tell you when these traumas will occur – not me, not Charlie {Munger], not economists, not the media. Meg McConnell of the New York Fed aptly described the reality of panics: “We spend a lot of time looking for systemic risk; in truth, however, it tends to find us.”

Buffet also has a very rational view about fear and risk that we take to heart here at Soundmark: “During such scary periods,” Buffet wrote, “you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well.”

At Soundmark we construct low-cost, tax efficient, and diversified portfolios based on our clients’ long-term financial plans. This allows you, our clients, to focus on what is most important in your life, including your family, business and personal pursuits while ignoring noise and short-term volatility in the market. If you or someone you know is concerned about market volatility or how to handle the next market correction, please feel free to contact us any time.

My next post will discuss the end of the bond bull market and what that means for a diversified portfolio.

 

Todd Flynn, CPA, CFP ® is a Principal at Soundmark Wealth Management, LLC. Todd works closely with physicians, business owners, and other high-net-worth individuals to help them define their financial goals and implement an ongoing financial planning process.