Staying Fully Invested in Stocks Is Insanity

In last week’s Money and Markets column, I showed the following chart, which uses the Shiller P/E ratio to measure the value of the U.S. stock market on a price-to-earnings basis.

In a nutshell, the Shiller P/E ratio is a metric popularized by economics Nobel Prize winner Robert Shiller that smoothes out short-term ups-and-downs in profits by using a 10-year earnings average. To develop his tool, Shiller tracked P/E ratios dating to the 19th century.

At its current level of 25.41, the Shiller P/E ratio is well above its long-term average of 16.47. In fact, it has been at a higher level only three other times in history since the late 1800s: 1. before the Great Depression; 2. prior to the bursting of the Internet bubble in 1999; and 3. just before the subprime collapse in 2008.

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The Shiller P/E now suggests that the market, which is trading at all-time highs, will return an average of 1.5 percent a year over the next decade, including dividends. If you remove the 2 percent-a-year contribution from dividends, the return will be negative. That means the S&P 500 will be lower 10 years from now than it is today.

Predicting where the market will go in the short run is a fool’s errand.

On the other hand, it’s well below the levels of 30 and 40 posted leading up to Nos. 1 and 2 above.

Many on Wall Street say stocks are still reasonably priced based on metrics such as the S&P 500’s forward price-to-earnings ratio, which currently stands at 15.5. But I disagree. That’s because forward estimates are based on analysts’ optimistic projections, which have been declining over the past several quarters as earnings growth has flat-lined.

Assessing the level of the market using the Shiller P/E or the S&P 500’s forward-price-to-earnings ratio has its limitations. While both can give you a general sense about whether the market is cheap or expensive as well as information about the prospects for long-term future returns, neither is particularly useful as a short-term timing indicator.

Indeed, the Shiller P/E ratio has shown that the U.S. stock market has been expensive for the past three years. Thus, if you had used that measure as your only guide about whether to invest in stocks, you would have missed a lot of the rebound from the market low in March 2009.

With the Federal Reserve recently saying it has no plans to taper its unprecedented stimulus program, no one knows how high the market can go because those monetary policies have never been tried before. Predicting where the market will go in the short run is a fool’s errand.

As we saw in the late 1990s, prior to the Internet bust, overvalued stocks can get even more overvalued. But at their current record highs, a full-on allocation to stocks seems appropriate for only the most aggressive speculators.

For those who are more cautious, the odds are not on your side. That’s why I say, hold positions you would be comfortable with if the stock market were to fall sharply and guard your capital because the risks are ramping up ever higher.

Best wishes,

Bill

Bill Hall is the editor of the Safe Money Report. He is a Certified Public Accountant (CPA), Chartered Financial Analyst (CFA) and Certified Financial Planner (CFP). Besides his editorial duties with Weiss Research, Bill is the managing director of Plimsoll Mark Capital, a firm that provides financial, tax and investment advice to wealthy families all over the world.