Opinion: What should investors do when the market is soaring?
The self-proclaimed fortuneteller Nostradamus published more than 6,000 predictions during his lifetime. With the benefit of hindsight, it’s easy to see that his prophecies had little substance or predictive value. In fact, in his day, even astrologers dismissed Nostradamus as incompetent.
But what if the person making a prediction is the opposite of Nostradamus? What if he is a serious individual, someone who is universally respected and whose forecasts have a demonstrated track record of success? Consider Robert Shiller, a Yale University economics professor and Nobel Prize winner, who has a reputation for making prescient calls. With his book “Irrational Exuberance”, he predicted the 2000 stock market crash. Later, he also foresaw the late-2000s housing market blowup. With that kind of track record, it seems worth paying attention to Shiller.
What is he saying about today’s stock market? Pointing to a measure he developed, the cyclically adjusted price-earnings ratio or CAPE, Shiller makes two observations.
First, the market SPX, -0.10% is more expensive today than at any other time since 1871—with one exception. That one exception? December 1999, just before the dot-com crash took the broad market down by almost 50%.
Second, among major world markets, the U.S. stands alone. In April, Shiller proclaimed the U.S. “the most expensive market in the world.” Since then, it has only gone up more.
Read: Opinion: This market can keep hitting one home run after another
If Shiller were the only one making these kinds of statements, they might be easier to explain away. But unfortunately, Shiller is not alone. There’s also Joel Greenblatt, author of “The Little Book That Beats the Market” and an investor whose track record puts him nearly in a league of his own. When he ran a hedge fund, Greenblatt delivered returns of 50% a year in his first 10 years. To put that in perspective, he took each dollar invested and turned it into $38, an astonishing accomplishment.
What is Greenblatt saying about today’s market? He sees what Shiller sees: The market is expensive. In fact, looking back over the past three decades, he believes it has rarely been more expensive.
With these kinds of observations, how should you, as an investor, respond? These are the steps I recommend:
First, be careful not to misinterpret these observations. Both Shiller and Greenblatt are quick to point out that these are observations, not predictions. Neither sees himself as a Nostradamus. While Shiller is confident that the market will correct at some point, he acknowledges that it’s very difficult to know exactly when that day will come. Meanwhile, Greenblatt’s research indicates that the market may actually continue to rise from here, albeit at a slower pace than in the past.
Second, use asset allocation to protect your nest egg. Remember, you incur a permanent loss only when you choose to sell something at a low price. The simplest way to sidestep such losses is to avoid being forced to sell any of your investments when the market goes through one of its periodic downturns. How do you accomplish that? By keeping a sufficient number of years of spending money outside the stock market to carry you through a typical downturn.
Third, avoid trying to “time the market.” In other words, don’t look to profit by selling when the market is high and then attempting to buy back later when it’s lower. While that sounds appealing in theory, it turns out to be very difficult in practice. This was proved most recently by Aswath Damodaran, a New York University professor and authority on investment valuation. Using Shiller’s CAPE Ratio, Damodaran tested a variety of market timing strategies. His conclusion: “I couldn’t find a single way you could use CAPE to make money from timing the market.”
Adam M. Grossman’s previous blogs include Stress Test, All of the Above and Not My Thing. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.
This column originally appeared on Humble Dollar. It has been published with permission.
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