After several years of rising US stock prices, I am often asked when the next crash, or at least next big correction, is coming. I believe it is foolish to try and time the market, but I do believe it makes sense to sell out of expensive assets and buy into better value assets (buy low, sell high) as cycles present themselves. Valuation is the key reason why I am now recommending an allocation to US stocks of less than 50%. For many investors, the main shift is putting more of your 401k and IRA in foreign stocks and US bonds, as I’ve seen most IRA accounts allocate way too large a percentage to US mutual funds.
The S&P 500 seems overpriced
As of this writing (summer 2018), the S&P 500 is trading at just over 20x trailing earnings, which may not seem too bad given an 11% average growth rate in US earnings over the past few years, but P/E ratios over 20 have historically meant lower returns over the next 10 years. The Nasdaq 100 (more heavily weighted towards large tech names like Apple and Amazon) is trading at even hotter valuations of over 25x times recent earnings, after an even more breathtaking 25% average annual earnings growth rate.
Are other foreign markets also overvalued?
Right now, large cap US stocks seem to be some of the most expensive in the world. As a group, the only other global sector I find just as overpriced are certain Chinese names and sectors, especially internet and health care, and especially in China A-shares.
Which foreign markets offer the best value investments right now?
Among the JUICE (Japan, US, India, China, Eurozone) markets I most look at, Japan and India seems “moderately priced” and in need of smarter stock selection, China has bargain-priced opportunities in certain sectors, and in the Eurozone, Italy has a few names priced for crisis rather than for perfection.
Beyond that, Russia’s and Turkey’s P/E ratios below 8 could be called “blood in the streets” prices, and the risks of “bottom fishing”, “catching a falling knife” and buying a “value trap” are what to worry about, rather than paying too much.
How do high stock valuations translate into lower returns?
Jack Bogle explains it well in the below video: you make money in stocks from a combination of the underlying business actually making money (stock return) and because someone else will pay you more for the same business (speculative return). The higher the P/E ratio when you buy, the lower your future speculative return and vice versa.