Are Stocks Too Expensive?

If you have read the financial news—or any news for that matter—in recent months, you will probably have come away with the impression that now is not a good time to buy stocks. But does that mean you should hoard your cash and dump it into the High Interest Savings Accounts where Home Trust and Oaken Financial are begging you for your money?

I don't use valuations to guide my investment strategy, but it's true that the #1 stock market in the world is looking pretty pricey these days. Shiller’s Cyclically Adjusted Price to Earnings ratio (CAPE) for U.S. stocks is sitting at an eye-popping 30. There have only been two times in history where this level has been hit before: Fall of 1929 and the period between 1997-2001.

We know what happened following these periods. The U.S. stock market dropped for several years in a row, declining 75% in value during the Great Depression. It also crashed and went nowhere for more than a decade after the 2000 peak.

Depending on who you ask and what metric you use, the future expected return on an investment in the U.S. stock market today is about equal to the expected inflation rate, ie. nothing in real terms.

That said, the U.S. market still has the potential to climb quite a bit more. The CAPE peak in 2000 was a massive 44. This implies, based on history, the market could climb another 45% and still not be the most expensive it has ever been!

Canada is definitely more attractive than the U.S. from a historical valuation perspective with a current CAPE of 20. Our expected future return—according to CAPE models—is around 4.5% annually.

Where Should You Invest Today?

If you’re a buy-and-hold, passive, or “Lazy” portfolio type of person, just stick to a broadly diversified global portfolio with regular re-balancing. A Growth/Balanced Portfolio will do fine. International stocks will form bigger parts of XAW.TO, the Canadian stock market offer commodity exposure, and bonds along with gold blunt the downside risks.

If you’re really nervous, it's a sign that you are taking on too much risk. Reduce risk by bumping up the bond allocation (I used HBB.TO in the portfolio) to 20%, or even 30%. Just make sure that, within the stock portion, you are still ¾ invested in XAW.TO to stay diversified.

I personally don’t invest in a passive portfolio. (That doesn't mean I don't think it's a great option which is likely to perform well in the long-run).

I am using momentum models: macro-style trend investing. While I believe in the benefits of buy-and-hold for the typical investor, I am willing to take more risks and be more active in my own portfolio.

I’m also fiercely logical and don’t get easily tempted into making rash decisions. Confidence and discipline are good attributes for any investor, but especially beneficial to more complex rules-based investing styles like the trend style which I am using.

I am willing to accept potentially lower returns in up markets in exchange for lower draw-downs in market corrections. While I will likely make minor tweaks to my strategy as my knowledge develops, I will not abandon it just because a passive strategy would have done better for a few years. I have a lot of confidence that my strategy will perform very well over time.

Opportunities Elsewhere

While U.S. and Canadian stocks are on the pricey side using these CAPE metrics, thankfully there are some great sections of the market which are very investable and trade at good ratios. We have an amazing selection of low-cost ETFs in Canada to take advantage of these opportunities.

Emerging Markets

My current favourite from a valuation standpoint is the Emerging Markets. Some countries might sound scary, but the price reflects it well. The CAPE of the Emerging Market index is currently at 13—well below the historical average of 17. The largest components like China, Brazil, Russia, and India are all below their historical CAPE averages.

The current valuation of the Emerging Index suggests a 30% gain just to hit the historical average. Even a 50% gain still puts it well below the long-term 75th percentile.

EM is also showing a very positive uptrend, trading higher in the past 6 months and 1 year. With my strategy, I am currently directing all new investments to Emerging Markets.

Developed International Markets

There is also great opportunity in the Europe, Asia, and Far East (EAFE) markets. The EAFE index is trading at a CAPE of 15 compared to a long-term average of 22.

To hit the long-term average, EAFE stocks can climb approximately 45% from current valuations.

The bigger components of the index, the U.K., Germany, France, Japan, and Australia are all trading pretty close to their long-term averages. However, some countries in the index—Spain and Italy for example—are very cheap right now.

Like Emerging Markets, the EAFE stocks are also in a very positive uptrend. They have climbed more than 15% in the last twelve months.

Currency Thoughts

Right now, thanks to oil prices, our petro-dollar is trading near the low end of most of the currencies represented in EAFE index.

I don’t know where our dollar is going to go in the short term, but it’s a pretty safe bet that some years down the road it will be higher than it is today. This will have a somewhat negative impact on international returns as we are always measuring our net worth in Canadian dollars.

For large portfolios—especially in registered accounts—it probably makes sense to use a hedged ETF for at least some of your portfolio. XFH.TO or VEF.TO will do the trick. You can always sell and move to an unhedged product when our dollar hits a certain level, like 0.85USD or something like that.

I wouldn’t use hedged products for Emerging Markets as their currencies tend to be linked to commodity prices as well. Also, they tend to be more expensive to hedge, making the benefit of hedging smaller.

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