Whether the market is overvalued is a complex question that depends on a number of factors and can be difficult to answer definitively. Some say the market is overvalued, while others argue that the high valuations are justified.
The CAPE ratio and P/E ratio of the S&P 500, which are both higher than historical norms, suggest stocks may be overvalued. There are many different methods for measuring valuations, and knowing which one is correct is not always evident. The
S&P 500 has shifted to include more tech companies, known for their high-profit margins and growth potential, so many argue the valuations should be higher because of this. The current backdrop of declining interest rates and inflation is also generally very supportive of equities.
It's also important to note that valuations are not good short-term indicators, and the stock market can remain overvalued or undervalued for a long time. US equity prices spiked after the election results, rising 4.9% and moving the market further into higher valuation territory as investors processed the implications of another Donald Trump presidency.
Not too long ago, on August 5th, the stock market experienced its most significant one-day selloff in two years, prompted by a weaker-than-expected jobs report and recessionary worries, among other factors. Since then, the downdraft and volatility have stopped, and optimism has returned to the markets. However, this should serve as a near-term reminder that things can quickly change.
On average, over the past decade, stock returns have been good, while bond returns have been disappointing. However, we are in a different (and more attractive) interest rate environment today, and reducing equities today can deliver multiple benefits for investors, including reducing risk in your portfolio, including the dreaded sequence risk (or the risk associated with the order or timing in which your investment returns occur); enabling you to lock in still-robust yields on safer securities, such as bonds, while you still can; and helping establish cash flows for the years ahead so you won’t have to worry about your portfolio’s yield or the market environment. These benefits can be desirable, as many people prefer to withdraw the income generated from their portfolios instead of the principal.
If you’re planning to or are actively spending from your portfolio and have to take the money out of depressed equities, you’re turning paper losses into actual losses. Building up your percentage of safer assets, as you do when you rebalance from stocks into bonds and cash, helps reduce the odds that you’d be a seller of stocks in such a downturn. Knowing that you have a healthy cushion of assets to spend before you’d have to touch stocks can provide peace of mind (and that’s hard to put a price on). Remember, if you’re selling stocks today, consider the tax implications, ideally making changes in tax-sheltered accounts to avoid triggering a hefty tax bill.
It is worth noting that there aren't any immediate catalysts for a stock market downturn. This earnings season is almost over and has been relatively strong. Ultimately, the decision to reduce risk in your portfolio may come down to balancing your risk tolerance (how much of a decline you are willing to accept in a downturn), risk capacity (how much of a decline you can mathematically accept in a market downturn), and peace of mind.
David Rosenstrock, CFP®, MBA, is the Director and Founder of Wharton Wealth Planning (https://whartonwealthplanning.com/ ). He earned his MBA from the Wharton Business School and B.S. in economics from Cornell University. He is also a CERTIFIED FINANCIAL PLANNER™.