The number one question we’ve been asked recently is whether stock prices have climbed too high and are due for a fall. It’s the natural question to ask after the S&P 500 reached 57 new highs last year and just had back-to-back years of 25%+ returns – something that has happened only three other times since 1928.
We know there’s plenty to worry about: the unpredictability in U.S. policy making, shifting geopolitics, the sense that the rules are changing . . . Plus, markets have pinned a lot of hope on Artificial Intelligence, which almost all of us agree is consequential, but few of us really understand. Risking real money on AI (or on anything) requires careful study and thinking – not just “this is going to be big.” Yet that seems to be enough for many.
Of course, our answer on where markets are headed is that we don’t know. We can never know if or when a correction is coming, how deep it will be, or how long it will last. That’s the nature of the beast. Just because stocks have done well does not mean they cannot keep doing well. At the same time, as prices climb, risk rises because more needs to keep going right for positive narratives to stay intact.
Still, not knowing does not mean we cannot prepare. Preparation is about thinking about the full range of possible outcomes, taking a stab at what seems most likely, but also understanding how your personal biases color your view, and then being prepared to be wrong.
Here’s my take: The U.S. economy is strong, corporate fundamentals are healthy, and consumers are in good shape. However, we still are relying on loose financial conditions and the high liquidity left over from a long era of low interest rates and fiscal generosity – even though rates have risen recently. If inflation stays stubborn, or worse, rises, liquidity will need to be constrained by interest rates that stay high or go higher. That would be bad for corporate earnings and the economy. And if that happens, it may be 10-year Treasury rates, not the technology sector, that become the driver for overall stock levels. That would require a wholly different kind of behavior than many have gotten used to.
In addition, despite the good corporate fundamentals, U.S. stock indexes do look expensive by many measures. Not all stocks – there are still values out there – but the opportunity set within the U.S. looks slimmer than it has been historically. Outside the U.S., opportunities look better.
Regardless of what happens from here, signs of expensiveness are a worry because they can augur subpar returns ahead. Return, after all, is a function of price paid, which is why “never overpay” is a great motto to stick with. Whether there is a “correction” or not, subpar returns can take many forms: They can be negative, or positive but lackluster relative to the risk-free rate or lower-risk instruments like bonds.
As an example, Vanguard’s long-term forecast for U.S. stocks is that they will return an average of 2.8% – 4.8% a year for the next 10 years. That’s a far cry from the 15% annual returns enjoyed the last decade. More pointedly, it’s a far cry from Vanguard’s forecast of 4.1% – 5.1% for low-risk U.S. Treasuries. For U.S. growth stocks, the 10-year forecasted return is even worse: just 0.4% – 1.6% a year, well short of Vanguard’s forecast for annual inflation over the next decade of 1.9% – 2.9%.
Of course, Vanguard’s view is just one of many possible outcomes. The point is not that we should accept Vanguard’s scenario. It is that die-hard bulls should prepare for the possibility that U.S. stocks could struggle to keep up with Treasuries. Likewise, pessimists should prepare for the good times possibly continuing.
And that brings us to diversification as a solution. It’s the same old boring answer we always hear. Yet, nothing is better as a form of preparation. In practice, diversification today could mean looking at non-U.S. stocks, holding “defensive” stocks, modulating amounts kept in bonds and cash, and taking small bets in real assets that might hedge against disaster. Hold your view but prepare to be wrong. Don’t bet the house on anything.
Another recommendation is to stay wise to your biases. I know I am biased toward skepticism, and that inclines me to respond more to warning signs than to good news – often to my detriment. Instead of expressing caution on this page, I could just as easily have made a resounding argument for strong U.S. markets persisting. As Charlie Munger once said, “I never allow myself to have an opinion on anything that I don’t know the other side’s argument better.” It’s a great reminder of how much work it takes to have an opinion at all. It’s also a great reminder to prepare to be wrong — and that is more than a mindset. It is also having a portfolio that can pivot, which points to diversification again.
When I am asked what personal qualities are most important to being an investor, my answer often is twofold: One is having a high sense of accountability – always taking responsibility for the things that go wrong as opposed to blaming, say, the market or your style being out of favor. The other is being prepared to change one’s mind, a quality that is in surprisingly short supply. So often, people come into investment meetings with their minds made up before discussion even begins – and then hold on tightly to their convictions. But the world requires adaptability.
In sum, let’s stay optimistic but be prepared for turmoil. Let’s also be highly selective, which means knowing precisely what you are looking for and doing your best to match it to what the world is offering. And finally, my personal plea: Let’s stay kind.
