With a bullish U.S. stock market stretching valuations to exceptionally high levels, you may well wonder what adjustments you should make to your portfolio.
These sky-high U.S. stock valuations have been driven by a tech boom led by the dominant U.S. tech behemoths, as well as a strong U.S. economy and optimism over perceived investor-friendly policies of incoming U.S. president-elect Donald Trump.
Some observers fear that high valuations could be a setup for a big stock market correction or even a bear market if less positive economic trends start to emerge.
But there are also indicators that the U.S. bull market still has lots of momentum behind it, so these high valuations could be sustained for some time.
So do you keep riding the U.S. bull market or look for a timely exit?
In my view, the most prudent response is nuanced and limited. High valuations provide good reason to consider relatively modest portfolio adjustments focused on maintaining balance and diversification.
In most cases, that should involve fine-tuning your asset mix without making big moves in the market.
While high valuations are a legitimate long-term concern, you can’t use high valuations to reliably predict what’s going to happen over a short period of time like the next year.
However, high valuations do make it likely you’ll achieve relatively low average returns for those high valuation stocks over the next decade or so, without helping to predict the timing of the market ups and downs that get you that outcome.
In response, if the value of your U.S. tech holdings have grown disproportionately compared with your other holdings, consider rebalancing into lower valuation assets to get back to a long-term asset mix that best fits your specific situation. That likely means trimming but not unloading your U.S. tech holdings if they’ve done particularly well.
The new tech boom
The dramatic rise of the benchmark S&P 500 index of large U.S. stocks has been increasingly led by a group of mammoth tech stocks known as the Magnificent Seven. On a combined basis, they now comprise roughly one-third of the S&P 500’s entire market capitalization.
Those seven stocks — Alphabet (formerly Google); Amazon; Apple; Meta Platforms (formerly Facebook); Microsoft; Nvidia; and Tesla — have been at the forefront of technological innovations for years, but they have received an extra boost recently from the artificial intelligence boom.
The current tech-led bull market is in sharp contrast to the dot-com bubble and bust that occurred at the turn of the century. That earlier episode included many startup companies with big dreams and nosebleed valuations but no tangible profits yet to show for it.
In contrast, the Magnificent Seven are all large, dominant, well-established growing companies that generate massive profits. While some or all of the Magnificent Seven may arguably be overvalued, they all have plenty of real financial substance behind them.
The Magnificent Seven have a combined price-earnings (P/E) ratio of 31, which has been instrumental in driving the P/E ratio of the S&P 500 as a whole to 22, based on recent figures provided by Yardeni Research. (These are “forward” P/E ratios that incorporate earnings estimates for 12 months ahead. P/E ratios can also be calculated on a “trailing” basis using actual earnings from the previous 12 months.)
Those S&P 500 valuations are exceptionally high based on historical comparisons and aren’t too far behind the S&P 500’s forward P/E ratio of 25 attained at the height of the dot-com boom in 1999, based on Yardeni Research figures.
Rising expectations are pushing valuations up
Behind the rising P/E ratios is the fact that while earnings of S&P 500 companies have been growing, increasing bullishness has caused stock prices to grow even more.
“Earnings have grown but that’s not mainly what’s driven returns over the last year,” says Dan Hallett, vice-president research at HighView Financial Group, a Canadian investment counsel firm. “It’s rising expectations. That’s what an expanding P/E represents and that’s where most of the returns have come from.”
Since expectations and P/E ratios can’t keep rising indefinitely, that makes it hard to sustain high returns derived from rising valuations for long periods of time.
“Even if the P/E ratio just stays at the high level it’s at now, you lose that tailwind,” says Hallett. “If the P/E ratio retreats, even a little bit, then you’re taking a pretty significant tailwind and turning it into a headwind.”
Research has shown that high valuations tend to lead to below-average subsequent returns (and vice versa) when measured over long time periods. For example, one recent study by U.S. investment firm LPL Financial found that high P/E ratios for the S&P 500 has resulted in lowered returns in subsequent 10-year periods, based on data going back to 1990. “The correlation between 10-year returns and valuations is compelling,” concludes the study, authored by chief equity strategist Jeff Buchbinder.
However, that and other studies have found that P/E ratios provide little or no indication of how returns will do over short periods of time like a year. “There is virtually no correlation between the index’s 12-month trailing P/E and its subsequent one-year return,” concluded the LPL Financial study.
“Valuation is not a helpful timing tool,” explains Hallett. “It is a good indication of future long-term returns in the sense that when valuations are much higher, future returns are probably going to be a fair bit lower, and vice versa.”
While high valuations don’t help with market timing, they do indicate an underlying vulnerability. “The more a market inflates during good times, the bigger downside moves tend to be once the good times end,” says the LPL Financial study.
Valuation differences support rebalancing
The practical implication of that is it usually doesn’t make sense for average investors to try to position their portfolio according to what they think will happen in the stock market in the next year, since that’s difficult or impossible to predict to any reliable degree regardless of valuation.
Instead, if you’re investing for the long-term, it makes sense for average investors to go with a long-term asset allocation that’s right for them and plan on sticking with it through the market’s short-term gyrations.
You should aim for a balanced and diversified portfolio of fixed-income and equities that fits your objectives, risk tolerance, time horizon and other individual circumstances.
When the actual asset allocation diverges substantially from the target, that should trigger rebalancing back to target by selling assets that have grown a lot in value and then using the proceeds to buy assets that have lagged in value. That should help reduce risk and enhance your returns to a modest but significant degree over a long period of time.
Valuation differences indicate potential opportunities for rebalancing. As it happens, valuations for stocks from Canada and non-North American developed markets are currently at significantly lower valuations compared to the S&P 500.
The forward P/E ratio for the MSCI World ex-U.S. Index is 14, as of Nov. 29. (That index represents stocks of large and middle-sized companies in developed countries excluding the U.S.) The forward P/E ratio for the S&P/TSX Composite Index of Canadian stocks is under 18, as of the same date.
Valuations for large parts of the U.S. market excluding the frothier tech companies are also comparatively lower, pointing to potential for rebalancing from tech stocks into other U.S. sectors.
When it comes to rebalancing into fixed income, yields for bonds and GICs have been coming down this year but are still reasonably attractive compared to what they’ve been over most of the last decade and a half.
